2012.cfa.l2.summary.ppt
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1
Ethical and Professional Standards
Study Session 1 – 2
Weighting 10%
2Overview of Level II Ethics
Code of Ethics
Standards of Professional
Conduct
CFA Institute Research Objectivity Standards
Study Session 1
Ethics Cases:- Glenarm
Company- Preston Partners- Super Selection
Other topics:- Fair dealing & disclosure- Changing investment objectives- Prudence in Perspective
Study Session 2
CFA Institute Soft Dollar Standards
3Overview of the Code and StandardsCode of Ethics
• Act in an ethical manner
� Integrity is paramount and clients always come first
• Use reasonable care and be independent
• Be a credit to the investment profession
• Uphold capital market rules and regulations
• Be competent
Standards of Professional Conduct
I: ProfessionalismA.Knowledge of the LawB.Independence and ObjectivityC.MisrepresentationD.Misconduct
II: Integrity of Capital MarketsA.Material Nonpublic InformationB.Market Manipulation
III: Duties to ClientsA.Loyalty, Prudence, and CareB.Fair DealingC.SuitabilityD.Performance PresentationE.Preservation of Confidentiality
IV: Duties to EmployersA.LoyaltyB.Additional Compensation ArrangementsC.Responsibilities of Supervisors
V: Investment Analysis, Recommendations, and Actions
A. Diligence and Reasonable BasisB. Communications with Clients and
Prospective ClientsC. Record Retention
VI: Conflicts of InterestA. Disclosure of ConflictsB. Priority of TransactionsC. Referral Fees
VII: Responsibilities as a CFA Institute Member or CFA Candidate
A. Conduct as Members and Candidates in the CFA Program
B. Reference to CFA Institute, the CFA Designation, and the CFA Program
4Standards of Professional ConductStandard I: Professionalism
I(A): Knowledge of the Law• Understand and comply with all laws, rules,
regulations (including Code & Standards) governing professional activities
• Comply with more strict law, rule, regulation• Do not knowingly assist in violation, otherwise
dissociate from activity
Guidance• Most strict• First – notify supervisor or
compliance• May confront wrongdoer directly• Dissociate if necessary• Inaction may be construed as
participation• No requirement to report violations
to governmental authorities, but this may be appropriate in certain cases
I(B): Independence and Objectivity• Use reasonable care, judgment to
achieve, maintain independence in professional activities
• Do not offer, solicit, accept any compensation that could compromise independence, objectivity
Guidance• Modest gifts OK• Distinguish between gifts from clients and gifts
from entities trying to influence• May accept gift from clients – must disclose to
employer – must get permission if gift is for future performance
• Investment banking relationships – do not bow to pressure to issue favorable research
• For issuer-paid research, flat fee structure is preferred
5Standards of Professional ConductStandard I: Professionalism
I(C): Misrepresentation• Do not make misrepresentations
relating to investment analysis, recommendations, actions or other professional activities
Guidance• Standard covers oral, written, or
electronic communications• Do not misrepresent qualifications,
services of self or firm, or performance record, characteristics of an investment
• Do not guarantee a certain return• No plagiarism – written or oral
communications
I(D): Misconduct• Do not engage in any professional
conduct involving dishonesty, fraud, deceit, or commit any act that reflects adversely on professional reputation, integrity, or competence
GuidanceThis Standard covers conduct that may not be illegal, but could adversely affect a member’s ability to perform duties
6Standards of Professional ConductStandard II: Integrity of
Capital Markets
II(A): Material Nonpublic Information• Members in possession of nonpublic
information that could affect an investment’s value must not act or cause someone else to act on the information
II(B): Market Manipulation• Do not engage in practices that
distort prices or artificially inflate trading volume with intent to mislead market participants
Guidance• “Material” – if disclosure of information would
impact a security’s price or if reasonable investors would want the information before making an investment decision
• Information is “nonpublic” until it has been made available to the marketplace
• Information made available to “analysts” is considered nonpublic until it is made available to investors in general
• Mosaic Theory
Guidance• Do not engage in transaction-
based manipulation – give false impression of activity / price movement; gain dominant position in an asset to manipulate price of the asset or a related derivative
• Do not distribute false, misleading information
7Standards of Professional ConductStandard III: Duties to Clients
III(A): Loyalty, Prudence, and Care• Act with reasonable care and exercise
prudent judgment• Act for benefit of clients and place their
interests before employer’s or own interests• Determine and comply with any applicable
fiduciary duty
III(B): Fair DealingDeal fairly, objectively with all clients
when:• Providing investment analysis• Making investment recommendations• Taking investment action• Engaging in other professional activities
Guidance• Take investment actions in client’s best interests• Exercise prudence, care, skill, and diligence • Follow applicable fiduciary duty• Manage pools of client assets according to terms
of governing documents• Make investment decisions in context of total
portfolio• Vote proxies responsibly and disclose proxy
voting policies to clients• “Soft dollars” must benefit client
Guidance• Different levels of service okay as
long as disclosed, and does not disadvantage any clients
• Investment recommendations: all clients must have fair chance to act on every recommendation
• Investment actions: treat all clients fairly – consider investment objectives, circumstances
8Standards of Professional ConductStandard III: Duties to Clients
III(C): Suitability• Know client’s risk and return
objectives, and financial constraints• Update information regularly• Make investment recommendations or
take investment actions that are consistent with the stated objectives and constraints
• Look at suitability in a portfolio context
III(D): Performance Presentation• When communicating investment
performance information, ensure that information is fair, accurate, and complete
Guidance• When in advisory relationship, gather
client information at the outset and prepare IPS
• Update IPS at least annually• Consider whether leverage (derivatives)
is suitable for client• If managing a fund to an index or other
mandate, invest according to mandate
Guidance• Do not misstate performance or
mislead clients about investment performance
• Do not state or imply ability to achieve returns similar to those achieved in the past
9Standards of Professional ConductStandard III: Duties to Clients
III(E): Preservation of ConfidentialityKeep current and prospective client information confidential, unless:• Illegal activities are suspected• Disclosure is required by law• Client or prospect allows disclosure of the information
Guidance• In some cases it may be required by law to report activities
to relevant authorities• This Standard extends to former clients• Exception: May provide confidential information to CFA
Institute for an investigation under Professional Conduct Program
10Standards of Professional ConductStandard IV: Duties to
Employers
IV(A): Loyalty• Must act for the benefit of their employer
GuidanceLoyalty – Independent practice:• If planning to engage in independent practice, notify employer of services provided,
expected duration, and compensation• Do not proceed without consent from employerLoyalty – Leaving an employer:• If seeking new employment, act in best interest of employer until resignation is effective• Do not take records or files without permission• Simple knowledge of names of former clients is OK• No prohibition on use of experience or knowledge gained at former employer Loyalty – Whistleblowing:• Permitted only if it protects client or integrity of capital markets• Not permitted for personal gain
11Standards of Professional ConductStandard IV: Duties to
Employers
IV(C): Responsibilities of Supervisors
• Must make reasonable efforts to detect and prevent violations
IV(B): Additional Compensation Arrangements� Do not accept gifts, benefits, compensation,
consideration that competes with, or creates a conflict of interest with, employer’s interest unless written consent is obtain from all parties involved
Guidance• Compensation and benefits covers
direct compensation by the client and other benefits received from third parties
• For written consent from “all parties involved,” email is acceptable
Guidance• Supervisors must take steps to
prevent employees from violating laws, rules, regulations, or the Code and Standards
• Supervisors must make reasonable efforts to detect violations
12Standards of Professional ConductStandard V: Investment Analysis, Recommendations, and Actions
V(A): Diligence and Reasonable Basis• Exercise diligence, independence, and
thoroughness
• Have a reasonable and adequate basis, supported by appropriate research, for any investment analysis, recommendation, or action.
V(B): Communication with Clients and Prospective Clients
• Disclose the basic format and general principles of investment processes and promptly disclose any changes that might affect those processes materially
• Identify important factors and include them in communications with clients/prospective clients
• Distinguish between fact and opinion in the presentation of investment analysis and recommendations
Guidance• Make reasonable efforts to cover
all relevant issues when arriving at an investment recommendation
• Determine soundness when using secondary or third-party research
• Group research and decision making: As long as there is reasonable basis for opinion, member does not necessarily have to agree with the opinion
Guidance• Distinguish between facts and opinions• Include basic characteristics of the security• Inform clients of any change in investment
processes• Suitability of investment – portfolio context • All communication covered, not just reports
13Standards of Professional Conduct
Standard V: Investment Analysis, Recommendations, and Actions
V(C): Record Retention• Develop and maintain appropriate records to support
their investment analysis, recommendations, actions, and other investment-related communications
Guidance• Maintain records to support research, and the
rationale for conclusions and actions• Records are firm’s property and cannot be
taken when member leaves without firm’s consent
• If no regulatory requirement, CFA Institute recommends retention period of 7 years
14Standards of Professional Conduct
Standard VI: Conflicts of Interest
VI(A): Disclosure of Conflicts• Must make full and fair disclosure to clients, prospects or employer of all
matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties
GuidanceDisclose to clients:• All matters that could impair objectivity – allow clients to judge motives, biases• For example, between member or firm and issuer, investment banking relations,
broker/dealer market-making activities, significant stock ownership, board service
Disclose to employers:• Conflicts of interest – ownership of stock analyzed/recommended, board
participation, financial and other pressures that may influence decisions• Also covers conflicts that could be damaging to employer’s business
15Standards of Professional ConductStandard VI: Conflicts of Interest
VI(C): Referral Fees• Must disclose to
employer, clients, and prospective clients
VI(B): Priority of Transactions• Investment transactions for clients and
employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner
Guidance• “Beneficial owner” – has direct /
indirect personal interest in the securities
• Client, employer transactions take priority over personal transactions (including beneficial ownership)
• Family member accounts that are client accounts must be treated as other client accounts
Guidance• Disclosure allows clients and
employers to evaluate full cost of service and any potential biases
• Disclosure is to be made prior to entering into any formal agreement for services
• Disclose the nature of the consideration
16Standards of Professional ConductStandard VII: Responsibilities as a CFA
Institute Member or CFA Candidate
VII(A): Conduct as Members and Candidates in the CFA Program• Must not engage in any conduct that compromises the reputation or
integrity of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA examinations.
GuidanceConduct includes:• Cheating on the exam• Disregarding rules and policies or security measures related to
exam administration• Giving confidential information to candidates or public• Improper use of CFA designation to further personal and
professional objectives• Misrepresenting the CFA Institute Professional Development
Program or the Professional Conduct Statement
17Standards of Professional ConductStandard VII: Responsibilities as a CFA
Institute Member or CFA Candidate
VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program • Must not misrepresent or exaggerate the meaning or implications of membership in
CFA Institute, holding the CFA designation, or candidacy in the CFA program
GuidanceCFA Institute membership:• Complete PCS annually• Pay membership dues annuallyUsing the CFA designation:• Don’t misrepresent or exaggerate the meaning of holding the CFA designationReference to the CFA program:• May reference participation but no partial designation• OK to say “passed all levels on first attempt,” but do not imply superior abilityImproper use of the CFA marks:• The “Chartered Financial Analyst” and “CFA” marks must always be used either
after a charterholder’s name or as adjectives, not as nouns
Failure to comply with results in an inactive member status
18
Definitions
I. General
III. Selection of brokers
Soft Dollar Standards
II.Relationship with clients
VI. DisclosureIV. Evaluation of
research
CFA Institute Soft Dollar Standards
VII. Record keeping
Appendix: Permissible research guidance
V. Client-directed brokerage
General Principles
19
Relationship with clients• Disclose involvement in soft dollar• OK to use brokerage from agency trades to obtain research – client should receive
some benefit• OK to use client brokerage obtained from principal trades to benefit other client
accounts, as long as disclosed
Selection of brokers• Consider trade execution capabilities
CFA Institute Soft Dollar Standards
General• Soft dollar practices must benefit client, whose interests always come first• Allocation of client brokerage – must not be based on amount of client referrals
investment manager receives from broker
Two fundamental principles• Client property• Duty to minimize transaction costs, obtain best execution & use client brokerage to
benefit clients
Soft dollar practices• The use of client brokerage by investment manager to obtain products/services to aid
manager in investment decision making process
20
Evaluation of research• Meet definition of Standard• Benefit client• Documentation of basis• Disclosure and consent obtained if benefit other clients• Investment manager pays for research if doesn’t meet criteria • Mixed-use research – allocate
Client-directed brokerage• Cannot use brokerage from another client to pay• Manager: Disclose duty of best execution• Disclose to client that client’s selection may adversely affect execution and adequacy
of research
CFA Institute Soft Dollar Standards34
Disclosure• Disclose types of third-party research received• To comply with Soft Dollar Standards, send client statement of practices annually• On client request, provide description of product / service obtained through client
brokerage generated by client’s account• Provide total amount of brokerage paid from all accounts (where manager has
discretion)
21
Record keepingManager must maintain records• Document arrangements obligating manager to generate specific dollar amount of
brokerage• Document client arrangements re: client brokerage• Document brokerage arrangements• Document basis for allocations – mixed use brokerage• Show how products / services obtained assist in investment process• Show compliance with CFAI Soft Dollar Standards, responsible party• Include copies of disclosures / authorizations from clients
CFA Institute Soft Dollar Standards
Permissible research: 3 level analysis• Level I: define the product or service• Level II: determine usage• Level III: mixed-use analysis – investment manager makes proper allocation
22
Objectives
Research objectivity
policy
Reasonable and adequate
basis
Procedures for compliance
Public appearances
Relationships with subject companies
Investment banking
CFAI Research Objectivity Standards
Personal investments and trading
Timeliness of research reports and
recommendations
Compliance and
enforcement
Disclosure
Rating system
Research analyst
compensation
23
Objectives of the Standards
• Prepare research, recommendations, investment action – clients always first• Full, fair, meaningful disclosures of conflicts• Promote effective policies/procedures – minimize conflicts affecting
independence/objectivity• Support self-regulation – adhere to specific, measurable standards, promoting
independence, objectivity• Provide ethical work environment
CFAI Research Objectivity Standards
Required Compliance Procedures
Research objectivity policy• Provide written policy on research independence and objectivity• Have supervisory procedures that ensure compliance• Have a senior officer who attests to the firm’s implementation and adherence
Public appearances• Require covered employees to disclose both personal and firm conflicts of interest to
the interviewer/host and, if possible, to the audience
24
Required Compliance Procedures
Reasonable and adequate basis• Appoint a supervisory analyst or a review committee to evaluate and approve
research report recommendations
Investment banking• Separate research analysts from the investment banking division• Research analysts are not supervised by or report to the investment banking• Investment banking or corporate finance divisions are unable to modify, review,
approve or reject research recommendations and reports
Research analyst compensation• Compensation should reflect the quality and accuracy of the recommendations made• Compensation should be not be connected to the analyst’s involvement with
investment banking or corporate finance activities
Relationships with subject companiesResearch analysts are not allowed to:• Share research report with a subject company prior to the publication of the research
report• Promise a favorable report or a certain price target to a subject company or corporate
issuer
CFAI Research Objectivity Standards
25
Required Compliance Procedures
Personal investments and trading• Firm should have policies to ensure covered employees’ personal investment
dealings are properly managed
Timeliness of research reports and recommendations• Reports should be issued on a timely and regular basis
Compliance and enforcement• Effective compliance procedures should be in place• The compliance procedures should be supervised and audited & maintain internal
audit records
Disclosure• Firm to provide full disclose of conflicts of interest
Rating system• Rating system should be helpful to investors in their decision-making process
CFAI Research Objectivity Standards
26
26
Recommended Procedures for Compliance
Research objectivity policy• Identify and describe covered employees• Covered employees to be trained regularly and indicate in writing their adherence to the
policy annually• Disclose conflict of interest that covered employees face • Identify factors on which research analysts’ compensation is based• Disclose the terms for the purchase of research reports by clients
Public appearances• Ensure that the audience of a presentation has enough information to make informed
judgments• Be prepared to disclose conflicts of interest• Firm should require research analysts that are participating in public appearances to
disclose investment banking relationship with the subject company and whether the analyst has participated in marketing activities for the subject company
• Research reports on the companies discussed should be provided to the audience for a reasonable fee
CFAI Research Objectivity Standards
27
27
Recommended Procedures for Compliance
Reasonable and adequate basis• Develop written guidance for judging what constitutes reasonable and adequate basis• Provide or offer to provide supporting information, and disclose current price of the
security
Investment banking• Prohibit research analysts from communicating with the investment banking or corporate
finance department prior to the publication of a research report• Investment banking or corporate finance personnel may review reports for factual
accuracies or to identify possible conflicts• Implement quiet periods for IPOs and secondary offerings• Analysts not be allowed to participate in marketing roadshows for IPOs and secondary
offerings
Research analyst compensation• Compensation should be based on measurable criteria• Direct link of analysts’ compensation with investment banking and corporate finance
activities is not allowed but firm should disclose to what extent analysts’ compensation depends on investment banking revenues
CFAI Research Objectivity Standards
28
28
Recommended Procedures for Compliance
Relationships with subject companies• Implement policies that govern analysts relationship with subject companies• Implement guidelines that only those sections of the report related to factual information
that could be verified by the subject company is shared before publication• Compliance and legal departments get a copy of the draft report before it is shared with
the subject company
Personal investments and trading• Approval required prior to trading in securities in the industries assigned to the analyst• Should have procedures to prevent employees from trading ahead of investing client
trades�Restricted period of at least 30 days prior and 5 days after a report is issued
• Analysts permitted to sell contrary to their recommendation when in extreme financial hardship
• Covered employees to provide a list of personal investments• Establish policies to prevent short-term trading of securities
CFAI Research Objectivity Standards
29
29
Recommended Procedures for Compliance
Timeliness of research reports and recommendations• Reports and recommendations should be issued at least quarterly• If the coverage of a firm is discontinued, a “final” research report should be issued
Compliance and enforcement• Distribute a list of activities that constitute violations and the disciplinary sanctions
Disclosure• Disclose investment banking or other corporate finance relationships & conflicts of
interests• Provide information on their recommendations and ratings• Disclose the valuation methods used to determine price targets, including risk factors
Rating system• Rating systems should include recommendation and rating categories, time horizon
categories, and risk categories• Absolute or relative recommendations are allowed• Employees should be prohibited from communicating a recommendation contrary to
the current published one
CFAI Research Objectivity Standards
30
Study Session 2 topics
The Glenarm Company
Applicationsof Standards
Preston Partners
Super Selection
Case Studies
Trade Allocation: Fair Dealing and Disclosure
Changing Investment Objectives
Prudence in Perspective
Ethics and Professional Standards
31
Quantitative MethodsStudy Session 3
Weighting 5 – 10%
32
Study Session 3
Time-Series Analysis
Multiple Regression
Correlation and Linear Regression
Overview of Level II Quant
33Covariance & Correlation
Covariance
• may range from +ve to –ve infinity• units are squared hence less meaningful
� �� ��
� �� �� �
�
n
t,1 1 t,2 2t 1
1,2
R R R Rcov
n 1
Correlation
• standardised measure of relationship• bounded by -1 and +1• the closer to absolute 1, the stronger the relationship
� �� 1,2
1,21 2
Covr
Significance of correlation coefficient
H0: = 0 Ha: 0
Two-tailed testDegrees of freedom are n – 2
Limitations to correlation analysis
•outliers affect the coefficient•spurious correlation: linear relationship but no economic explanation•a nonlinear relationship exists which cannot be captured by correlation2
r n 2t = 1 r
�
�
34Linear Regression
x
x
xx
xx
x
x
x
xx
x
x
x
x
x
x
xx
Y, dependentvariable
Xi
�i error termor residual
ii XbbY 10ˆˆˆ �
X, independentvariable
Yi
iY
Basic idea: a linear relationship between two variables, X and Y. Note that the standard error of estimate (SEE) is in the same units as ‘Y’ and hence should be viewed relative to ‘Y’.
Mean of �i values = 0Standard deviation of �i =standard error of the estimate (SEE)
Least squares regression finds the straight line that minimises the SEE by minimising:
SSE) errors, squared theof sum ( � 2i �
35Significance of coefficients
Hypothesis Tests on a Regression CoefficientTo test statistical significance:
H0: bi = 0 Ha: bi 0
Other tests are possible, for example:
H0: bi 1 Ha: bi < 1
Confidence interval for the population value of a regression coefficient
Predictions for the dependent variable
Given the estimated regression coefficients and an assumed value for the independent variable(s) we
can predict the value of the dependent value using:
Degrees of freedom = n – (k + 1)
i
iii s
bbt ,statistic Test ��
ii b of error standard s :Where �
� �ii svalue t criticalb ��
110i XbbY �
Confidence interval for the prediction of Y
n – 2 degrees of freedom
� �fsvalue-t criticalY ��
��
���
���
� 2
222
)1()ˆ(11x
f snXX
nSEEs
36
i10i XbbY � � � SSEY-Y2
ii �
� � SSRY-Y2
i �
� � SSTY-Y 2i �
iY
0b
Y
X
Y
Components of Variation
Total variation = sum of squared totals (SST) = actual - expected
Explained variation = sum of squared regressions (SSR) = predicted – expected
Unexplained variation = sum of squared errors (SSE) = actual – predicted
37
Analysis of Variance Table
Coefficient of determination
R2 = explained variation in ytotal variation in y
R2 is the proportion of the total variation in y that is explained by the variation in x’s
R2 = r2 for linear regression
InterpretationWhen correlation is strong (weak, i.e. near to zero)•R2 is high (low)•Standard error of the estimate is low (high)
Standard Error of Estimate
Source of Variation
Degrees of Freedom
Sum of Squares Mean Square
Regression (explained)
1 = k Regression sum of squares (RSS) Mean sum of squares (MSR) =
RSS/kError (unexplained)
n – (k + 1) = n - 2 Sum of squared errors (SSE)
Mean squared error (MSE) = SSE/(n – 2)
Total n - 1 Sum of squares total (SST)
SSTRSS
�
� � � � MSE1kn
SSE1kn
�SEE
n
1ii
� �
� �
�
�
ANOVA, SEE and R-squared
38
General form of model:
Predicting the dependent variable
ikk22110i Xb....XbXbbY � �
Independent variables
Dependent variable
Partial slope coefficientsY-intercept
Error term, residual
st variableindependen theof valuesassumed theareX.....,X,X
b....,b,b parameters regression for the estimates are b....,,b,b
:where
k21
k10k10
kk22110i Xb....XbXbbY �
Multiple Regression
39
Hypothesis tests on individual regression coefficients
To identify which independent variables are individually important in a multiple regression we perform a t-test on each slope coefficient with bi = 0. (seen earlier)
Degrees of freedom = n – (k + 1)
Determining the collective significance of the independent variables
Perform an F-test:
H0: None of the independent variables significantly explain the dependent variable.
b1 = b2 = b3 = …… = bk = 0Ha: At least one of the independent variables significantly explains the dependent variable. At least one bi 0Reject H0 if computed F > F-critical
Test statistic:
i
iii s
bbt ,statistic Test ��
ii b of error standard s :Where �
� �)1k-(nerrors squared of Sum
ksquares of sum Regression
F
�
table) ANOVA from (data MSEMSR
error squared Mean squares of sum regression Mean
�
�
Looking up the critical F-value
Use table corresponding to the significance level of test (�) i.e. (one-tailed!!!!)Numerator dof = k
Denominator dof = n – (k + 1)
Significance of coefficients
40Other Issues in Multiple Regression
Adjusted R2
• As you incorporate more variables R2 can only go up, even if some of the new variables are statistically insignificant
• Hence in multiple regression we use adjusted R2. This measure of fit does not automatically increase when another variable is added.
No calculations are required
Qualitative independent factors• These are variables that attain
discrete states, rather than taking values from a range.
• We use Dummy Variables for these factors.
• To distinguish between n categories, we need n-1 dummy variables.
� � � �� ��
���
���
���1-kn
1nR11R 22
Qualitative dependent variables with binary outcomes• Logit models - estimate the probability that the event will occur based on logistic
distribution• Probit models - as with logit, except based on normal distribution• Discriminant models - based on regression analysis, but producing a score which
can then be used to assess likelihood of event (e.g. credit scoring)
Interpreting p-values• A p-value is the smallest
significance level ( ) at which we can reject H0
41
Assumptions of a multiple regression model
1. The relationship between the dependent variable, Y, and the independent variable, X, is linear
2. Expected value of the error term is 0
3. The variance of the error term is the same for all observations (homoskedasticity)
4. The error term is normally distributed
5. The error term is uncorrelated across observations (i.e. no serial correlation)
6. No linear relationship exists between two or more independent variables (i.e. no multicollinearity)
Limitations of regression analysis1. Regression relations change over
time (non-stationarity)
2. If assumptions are not valid, the interpretation and tests of hypothesis are not valid
Violations of regression assumptions1. Heteroskedasticity – error term has
non-constant variance
2. Serial correlation – error terms are correlated with each other
3. Multicollinearity – linear relationship between independent variables
Assumptions, Limitations, Violations
42
Description• Variance of the error term is non-
constant.
• Unconditional: Not related to independent variables � causes no major problems.
• Conditional: related to independent variable � this is a problem.
Correction• Compute robust standard errors
(aka White-corrected standard errors) used to recalculate the t statistics
Effect on statistical inference• Estimated standard errors of the
regression coeffs. are likely to be wrong.
• With financial data they are likely to be too small, hence actual t-stats too high, so coefficients might appear significant when they are not (Type I error).
Detection•Scatter diagrams (plot residual against each independent variable and against time).•Breusch-Pagan test: regress the residuals2
against the independent variables, then test the significance of the resulting R2 using a one-tailed chi-square test. A significant value is evidence of heteroskedasticity.
Heteroskedasticity
43Serial Correlation
Description• Autocorrelation (serial correlation)
arises when the residuals are correlated with one another
• Usually arises with time series data
• Autocorrelation may be positive or negative
Correction• Adjust the coefficient
standard errors, e.g. using the Hansen method (which also corrects for conditional heteroskedasticity)
• Improve the specification of the model.
Effect on statistical inference• Positive autocorrelation can lead to too
low estimates of coefficient standard errors, hence too large t-stats, causing Type I errors.
• Negative autocorrelation can cause the standard errors to be overstated, causing Type II errors.
Detection (if not autoregressive model)•Scatter plot of residual errors •Calculate the Durbin-Watson Statistic, DW 2(1 - r).
Where r = sample correlation coefficient between consecutive residuals
0 2 4dL dU 4-dL4-dU
Evidence of positive
autocorrelation
Evidence of negative
autocorrelationNo evidence ofautocorrelationTe
st is
am
bigu
ous
Test
is
ambi
guou
s
44Multicollinearity
DescriptionTwo or more independent variables are mutually correlated, making the interpretation of the regression output problematic.
CorrectionRemove one or more of the
offending independent variables
Alternatively perform a more advanced technique such as stepwise regression
Detection• Conflicting t- and F-tests: significant F-statistic
combined with insignificant individual t-statistics• High correlation coefficient between two
independent variables (rule of thumb: > 0.7 but works only if no more than two independent variables are present)
• When dealing with more than two independent variables, low pair correlations could still lead to multicollinearity
• Signs on the coefficients that are opposite to what is expected
Effect on statistical inference• Inflates SEE and coefficient standard
errors leading to lower computed t-stats
• As a result, the null is rejected less frequently leading to Type II errors
45Model Specification Issues
biased and inconsistent regression coefficients
Leading to:
Unreliable hypothesis testing and inaccurate predictions
Examples of misspecification:• Omitting a variable
• Failing to transform a variable[e.g. using market cap as an independent variable instead of ln(market cap)]
• Incorrectly pooling data[e.g. using data spanning two distinct monetary policy regimes when building a model to predict inflation]
• Using the lagged value of the dependent variable as an independent variable
• Forecasting the past[using variables measured at the end of a period to predict a value in the period]
• Errors in the measurement of the independent variables
Model Misspecification
causes:
46
Trend ModelsVariable is a
function of time
Moving-Average (MA) models
Variable is a function of weighted average of previous error terms
Autoregressive (AR) models
Variable is a function of earlier value(s) of itself
Autoregressive Moving-Average (ARMA) models
A hybrid approach
Autoregressive Conditional Heteroskedasticity (ARCH) modelsUsed when variance of the error term
is dependent on the size of earlier errors
Types of Time-Series Models
47Trend Models
Linear trend modelValue of time series in period t,
yt = b0 + b1t + �t
Average change in y is constant in absolute terms = b1
Log-linear trend modelThe natural log of the value of time series in period t,
ln(yt) = b0 + b1t + �t
Exponential trend: average rate of change in y is constant = eb1 – 1
Might be a better model to use if a linear trend model produces serially correlated errors.
Limitations of trend model• The one independent variable may be
insufficient to explain changes in the dependent variable.
• Model errors are often serially correlated (use DW to detect) and hence assumption violated.
data series
straight line of best fit
y
t
t
y Observation
Trend
48
Exists if time series data is well-behaved,
so process can be represented with a
relatively simple model (e.g. AR)
Covariancestationarity
E.g. AR(p):
xt = b0 + b1xt-1 + b2xt-2 + … + bpxt-p + et
Series has:• constant mean• constant variance• constant covariance
with itself over time
If not covariance stationary then
regression results, both statistically & financially,
are meaningless
Mean reversionTime series has tendency to
converge to its mean:
Necessary condition for
parameters to be estimated by AR
regression methods
No finite mean-
reverting level � not
covariance stationary
First differencingmight help a time
series achieve covariance stationarity
� �1
0
b1b :AR(1) For�
Autoregressive Models
49
Chain rule of forecastingInputs used in multi-period forecasts are themselves
forecasts
xt = b0 + b1xt-1 + b2xt-2 + … + bpxt-p + t
Random walksValue in one period is equal to the value in previous period plus a random error:
xt = b0 + xt-1 + t
If b0 0 then random walk with drift
This is an AR(1) model with b1 = 1
Known as a unit root hence the mean reverting level is undefined
Serial correlation• Serial correlation within an AR model
causes estimates of the regression coefficients to be inconsistent � big problem.
• Cannot test for it using the DW statistic.
• Instead use a t-test to see whether any of the residual lag autocorrelations differ significantly from zero.
• If some are significant then the model is incorrectly specified.
• Increase the order of the model by incorporating the offending lags.
• In case of seasonality, add xt-4 for quarterly data, and xt-12 for monthly data
No finite mean-
reverting level � not
covariance stationary
Autoregressive Models cont.
50
Qth order moving average model, MA(q)
xt = �t + �1�t-1 + �2�t-2 + … + �q�t-q
• A time series will be well represented by a MA(q) model if the first q autocorrelations of that time series are significantly different from 0, while subsequent autocorrelations equal 0 (the autocorrelations drop suddenly to 0 after the first q)
• With most AR time series the autocorrelations start large and decline gradually as the lags increase.
ARMA modelsCombines both autoregressive lags of the dependent variable and moving-average errors.
Problems:
• Parameters can be very unstable - slight changes in data sample or initial guesses of parameters can give very different final estimates
• Choosing the right model is more art than science
• Model may not forecast well - in most cases a much simpler AR model will do as good a job
• Require large amounts of data (at least 80 observations)
Moving Average Models
51
Description of heteroskedasticity• Variance of the error term is non-
constant.
• Unconditional: Not related to independent variables � causes no major problems.
• Conditional: Is related to independent variable � this is a problem.
Correction• Compute robust/corrected standard
errors (aka White-corrected standard errors) or
• Use an ARCH model to forecast the variance of the error term
Autoregressive Conditional Heteroskedasticity
• Variance of error terms in one time period is dependent on the variance of the error terms in another period.
• SEs of the regression coefficients in models will be incorrect and hypothesis tests will be invalid.
• ARCH(1) detected by performing following regression:
(ut is an error term)
• If a1 is statistically different from zero then the series is ARCH(1).
• Can then use ARCH model to predict variance of errors with the following equation:
tuaa � 21-t10
2t ˆˆ ��
ARCH Models
2t10
21t ˆˆ �� aa �
52
In-sample vs Out-of-sample forecast errors• In-sample forecasts are for values within the estimation period. Can use the SEE to
compare the in-sample errors of competing models.
• Out-of-sample forecast errors represent the differences between actual and predicted values of the time series outside of the period used to construct the model.
• Can use the RMSE (Root Mean Squared Error, i.e. the square root of the average squared forecast error) to judge which model is most accurate.
The Dickey-Fuller (DF) Test for a Unit Root
• Test is based on a transformed version of the AR(1) model xt = b0 + b1xt-1 + �t
• Subtracting xt-1 from both sides produces:xt - xt-1 = b0 + (b1 – 1)xt-1 + �t or xt - xt-1 = b0 + g1xt-1 + �t where g1 = (b1 – 1)
• If there is a unit root in the AR(1) model, then g1 will be 0 in a regression where the dependent variable is the first difference of the time series and the independent variable is the first lag of the time series.
• DF test: H0: g1 = 0, time series has a unit root and is nonstationaryHa: g1 0, time series does not have a unit root
• Test is conducted by calculating a t-statistic for g1 and using a revised set of critical values computed by DF.
Other Issues in Time Series
53
Cointegration• Two time series are cointegrated if a long-term financial or economic relationship
exists between them such that they do not diverge from each other without bound in the long run (e.g. they share a common trend)
With a simple regression the following scenarios are possible:1. Neither time series
has a unit rootCan safely use linear regression
2. One or other time series has a unit root
Error term in the regression will not be covariance stationary � one or more regression assumptions violated �regression coefficients might appear significant when not
3. A) Both time series have a unit root but are not cointegrated
As with 2. above
3. B) Both time series have a unit root but are cointegrated
Error term in the linear regression will be covariance stationary but we should be very cautious in interpreting the regression results. The regression estimates the long-term relation between the two series but may not be the best model of the short-term relation.
Multiple Time Series
54
Start
Time Series - Summary
55
EconomicsStudy Session 4
Weighting 5 – 10%
56
Study Session 4
Economic Growth
Regulation and Antitrust PolicyIn a Globalized Economy
Trading with the World Currency Exchange Rates
Foreign Exchange Parity Relations
Measuring Economic Activity
Overview of Level II Economics
57Economic Growth
� Real GDP = measure of inflation-adjusted income and output� Standard of living = level of real GDP per labor hour = level of labor productivity� Economic growth = % change in real GDP per labor hour = growth in labor productivity =
improvement in standard of living
� Rule of 70: a country’s economic activity will double every (70/growth rate) years
58Economic GrowthPRECONDITIONS FOR ECONOMIC GROWTH
Theories of Economic Growth
• Markets• Property rights• Monetary exchange
New Growth Theory
Neoclassical Growth Theory
• Saving and investment in new capital
• Investment in human capital• Discovery of new technologies
For economic growth
to continue
Classical Growth Theory GDP growth will be driven back to the subsistence level
LT GDP growth requires technological change
Discovery of new products and techniques is down to luck
At a given level of technology, on average, a 1% increase in capital per labor hour results in a one third of 1% increase in real GDP per labor hour
PRODUCTIVITY
One Third Rule Methods for Increasing Economic Growth
• Encourage savings• Encourage basic R&D• Stimulate international trade• Improve the quality of education
59Regulation and Antitrust Policy
Governmentregulation
Social regulation
Economicregulation
Based upon� Product quality� Product safety� Employee safety
Natural Monopolies� Cost-of-service regulation� Rate-of-return regulation
Negative Side Effects� Creative response� Feedback effect
Regulator Behavior Theory
Capture Theory� Industry controls
regulator
Share-the-gains, Share the Pains Theory
� Legislators� Customers� Regulated firms
60Trading with the World
� Comparative advantage refers to the lowest opportunity cost to produce a product. � Law of comparative advantage: trading partners can be made better off if they specialize
in producing goods for which they are the low-opportunity-cost producer and trade for the goods for which they are the high-opportunity-cost producer
Restrictions on Trade� Tariff is a tax imposed on imported goods� Quota is a limitation on the quantity of goods imported� Voluntary export restraints (VERs) are agreements by exporting countries to limit the
quantity of goods they will export to an importing country� Two primary forces underlying trade restrictions:
� Governments like tariff revenue� Domestic producers affected by lower-cost imports use political means to gain
protection from foreign competition
61Currency Exchange Rates
Foreign Exchange Quotations
Direct Quotes• DC/FC• Usual method of
quoting currencies
Indirect Quotes• FC/DC
Triangular Arbitrage
Profit is calculated by “going around the triangle”.
Choose the way > 1
Always sell the base currency and by the quoted!
USD
CHF GBP1.5600
USD/GBP
2.3182 CHF/GBP
1.486
0
CHF/USD
USD GBP CHF USD or
USD CHF GBP USD
£/$ x CHF/£ x $/£ or
CHF/$ x £/CHF x $/£
£:$ £ base $ quoted
£/$ $ base £ quoted
62Triangular Arbitrage
Bid and Ask
$
€
“BID”meansturning€ into $
“ASK”meansturning$ into €
CHF GBP
1.3500 USD/GBP
Ask rate = ?.???? CHF/GBP
1.50
00 C
HF/U
SD1.
5010
CHF
/USD
Bid Rate = ?.???? CHF/GBP
1.3510 USD/GBP
63Currency Exchange RatesBid – Ask Spread
Factors affecting spread:• Volume• Volatility• Dealers long/short position• Term (forward contracts
only)
Triangular Arbitrage1. Choose a direction and formulate equations:
£/$ x CHF/£ x $/CHF2. Check examiner has given the quotes for the
right base and quoted combinations.If not you will need to take reciprocals noting that the bid and ask swap when you do
3. Using the bids move round the triangle selling the base and buying the quoted currency
4. Did you get > 1? If not take the reciprocal of the ask quotes to move the opposite direction.
USD
CHF GBP
£/$ 0.7113 – 0.7116
Bid (lower)
Bank sells £
Bank buys $
Ask (higher)
Bank sells $
Bank buys £
Forward Contracts
Premium – base currency buys more future quoted
Discount – base currency buys less future quoted
Fwd – Spot
Spotx
360
Contract Days
Fwd Pm or Disc =
64
Factors That Cause a Currency to Appreciate/Depreciate
� Differences in income growth: Country with rapid income growth has more demand for imports and foreign currency, domestic currency depreciates
� Differences in inflation rates: Higher inflation means exports more expensive, imports cheaper, domestic currency depreciates
� Differences in real interest rates: Country with higher real rates will attract foreign investment, increased demand for domestic currency so it appreciates
� A fixed rate system has a set rate of exchange to another currency� A currency board creates domestic currency only in exchange for the other currency, held in
bonds and other liquid assets. The currency board promises to redeem the domestic currency at the fixed exchange rate into dollars
� A pegged exchange rate system is based on a commitment to use monetary policy to keep exchange rates within a band
Other Exchange Rate Regimes
Foreign Exchange Parity Relations
65
Fiscal Policy and Exchange Rates
Expansionary monetary policy leads to:� Rapid economic growth (increases imports)� Higher inflation (decreases exports)� Lower real interest rates (increase investment to abroad)All three cause the domestic currency to depreciate
Monetary Policy and Exchange Rates
� Unanticipated restrictive fiscal policy leads to:� Slower growth (decreases imports) appreciation� Lower inflation (increases exports) appreciation� Lower real interest rates (increases investment abroad)
depreciation� Financial capital is more mobile, so third effect dominates in
short run� Expansionary policy Short run appreciation
Foreign Exchange Parity Relations
66
Purchasing Power Parity� Based on the “Law of One Price”� Absolute PPP: Same basket of goods will cost the same everywhere, after
adjusting for exchange rates� Relative PPP: Changes in exchange rates will just offset changes in price levels
(i.e., differences in inflation)
Uncovered Interest Rate Parity• Countries with high interest rates (and high inflation rates) should have currency values that
fall over time• Assumes PPP and Fisher hold• Assumes constant real exchange rate
International Fisher Relation• Inflation differentials between countries are the prime drivers of interest rate differentials• Key = real interest rates the same in every country!
Foreign Exchange Parity Relations
Covered Interest Rate Parity• Forward rates are arbitrage free rates set using interest rate differentials.
67Foreign Exchange Parity Relations
International Fisher Effect
SpotForward
InterestRate Parity
PurchasingPower Parity
The forward rate is the best unbiased predictor of the future spot rate
Uncov
ered
Inter
est
Rate P
arity
B
QINT1
INT1
+
+
0t
SpotFuture Spot
)REAL1)(INF1(
)REAL1)(INF1(
B
Q
++
++
68
Purchasing Power Parity Interest Rate Parity (covered)
Parity Relationships
International Fisher EffectExact Methodology:1+r = (1+real r)(1+E(i))
Linear Approximation:r = real r + E(i)
Where:r = nominal interest ratereal r = real interest rateE(i) = expected inflation
Uncovered Interest Rate Parity
Foreign Exchange Parity Relations
Foreign Exchange Expectation Relation
E(S) = F
E(% S) = F - SoSo
E(ST) = So x (1+Iquoted)T
(1+Ibase)TFwd = So x
(1+Rquoted)
(1+Rbase)E(ST) = So x
(1+Rquoted)
(1+Rbase)
69Measures of Economic Activity
Gross Domestic Product (GDP)
Total market value of all final goods
and services provided in a
country over a stated period of time
(1yr)
Gross National Income (GNI)
Total goods and services produced by the citizens of a
country
Net National Income (NNI)
GNI less depreciation.
Amount of resources utilized or worn out by the production process
Value of production- cost of inputsGDP
Output
Consumption+ InvestmentTotal domestic expenditure+ Exports of goods and servicesTotal final expenditure- Imports of goods and servicesGDP
Expenditure
Wages and salaries+ Self-employment income+ Company trading profits+ Government and enterprise
trading surpluses+ Rental incomeGDP
IncomeGDP+ net property income from abroadGNI- DepreciationNNI
Can be expressed in current or constant prices
GDP at market prices – indirect taxes + subsidies = GDP at factor prices
70
Financial Reporting & Analysis
Study Sessions 5, 6 & 7
Weighting 15 – 25%
71Overview of Level II FSA34
Inventories
Intercorporate Investments
Study Session 5
Multinational Operations
Study Session 6
Employee Compensation
Long-Lived Assets
Integration of Financial Statement Analysis Techniques
Study Session 7
The Lessons We Learn Financial Reporting Quality
72Inventories
With inflation and LIFO, COGS is higher and end. inv. is lower.
With deflation and LIFO, COGS is lower and end. inv. is higher.
Weighted average cost is in between FIFO and LIFO.
Inventory methodsPerpetual vs. Periodic
SystemsPerpetual: updates inv. after each purchase/sale.
Periodic: records purchase/sale in "Purchases" account , inv./COGS determined at period end.
LIFO reserve will increase with rising prices and stable/increasing inv.inv FIFO = inv LIFO + LIFO reserve .COGS FIFO = COGS LIFO –
LIFO reserve.NI = LIFO reserve
(1-t).
LIFO reserveUnder LIFO, inv. purchased last is treated as if it’s sold first.
LIFO liquidation occurs when a company appears to sell the inventory it purchased first.
LIFO liquidationUnder IFRS: Lower of cost or NRV, NRV = sales price - selling cost
Under US. GAAP: Lower of cost or market (replacement cost), NRV < Market < NRV – Normal profit margin
Inventory valuation
73Long-lived assets
IFRS: Annually, CV vs. recoverable amount (FV-selling cost), can be reversed
US. GAAP: Tested, two steps: recoverability test, then measuring the loss, loss recoveries are prohibited
Impairment Long-lived assets disclosure
Fixed asset useful life, Fixed asset SV, Depreciation method, Useful calculations regarding a firm’s FA: average age, average depreciable life, remaining useful life
In the year of impairment: NI lower, ROA & ROE will decrease
In subsequent year: lower depreciation, NI higher, ROA & ROE will increase
Impact of Impairment US GAAP: upward revaluation is prohibited, except for long lived assets held for sale
IFRS : permitted
Upward revaluation: A & E increase, D/E decrease, subsequent periods: Higher depreciation, Lower ROA and ROE
Revaluation to FV
74Leases
transfer title
bargain purchase option
75% of the asset’s economic life
90% of the fair value of the leased asset
Capital lease criteria
Capital lease:
Sales-type lease: Manufacturer, dealer, PV of the lease payments is greater than carrying value of the leased asset (COGS)
Direct financing lease
Lessor: capital vs. operating lease
Relative to operating leases, capital leases will make assets higher, liabilities higher, net income (early years) lower, CFO higher, CFF lower, total cash flow the same, EBIT higher
Lessee: capital vs. operating lease
75Intercorporate Investments
shares are a genuine small investment for dividend/capital gains purposes
<20% votesshares are to ensure a significant influence is exerted over the other company (but NOT outright control)
“Affiliate/Associate”
Equity Account
20 – 50% votesshares are to take over and control the company
“Subsidiary”
Consolidate (Purchase method)
Pooling (Merger method)
> 50% votes
Secondary market?
No
Held-to-maturity securities
Available-for-sale securities
Trading securities
Yes
Debt securities which the company intends to hold to maturitySecurities are carried at amortized cost
May be sold to satisfy company needsDebt or equityCurrent or non-currentCarried in the balance sheet at market valueIncome statement same as cost method
Acquired for the purpose of selling in the near termCarried in the balance sheet as current assets at market valueIncome statement includes dividends, realised & unrealised gains/losses
B/S Historic CostI/S Dividends/Int
76Equity AccountingEquity Accounting: Significant Influence“One line consolidation”Initially recorded at purchase price (cost)Subsequent periods:B/S: Cost + earnings pickup – dividends� B/S = %Share x � Retained earningsI/S: Earnings pickup (% share of NI)
Purchase Price > Book Value
Investment initially recorded at cost
However within cost:
% Net Assets Acquired
%FMV adjustments
Goodwill
Cost paid
$m
X
X
X
X
FMV adjustments impact future earnings
Adjust earnings for up/down stream inter group unearned profits
Impairments
Carrying value > Fair value
Decline considered permanent
No reversal (US GAAP)
Reversal allowed (IAS)
UpstreamProfits recognized in investee I/SUnconfirmed profits –eliminate pro-rata share
DownstreamProfits recognized in investor I/SUnconfirmed profits –eliminate pro-rata share
Fiscal years beginning post Nov 2007 IFRS 159Can elect to hold investment at fair value with changes in fair value taken to the I/SConvergence with IAS 28/39
77Joint VenturesJoint Ventures•Equity account: Required US GAAP Permitted IAS“one line consolidation”•Proportional consolidation recommended by IAS“line by line proportional consolidation
• Report pro-rata share of all accounts, net out intercompany transfers
• Make both sides of intercompany adjustments in joint venture accounts
• No minority interest (consolidated on the basis of ownership not control)
• The rest is as per a normal consolidation
• Interest cover - overstated
• Return on assets - overstated
• Debt ratios skewed
Stockholders equity, Net Assets and NI same under both methods
Total asset and total liabilities differ
Big impact on ratios
78Consolidation (Purchase Method)
Steps
1. Record any finance raised in parent company’s balance sheet
2. Record investment in subsidiary in parent’s balance sheet.
(Investment recorded at purchase price)
3. Adjust subsidiary identifiable net assets to fair market value (IAS 100% of FMV adjustments, US GAAP parents share of FMV adjustments)
4. Calculate goodwill on acquisition
Proceeds
% Identifiable Net Assets
Goodwill
5. Eliminate inter-company transactions
6. Add together assets and liabilities 100% regardless of ownership
7. Eliminate investment in parent company’s books
8. Include Common Stock and Additional Paid in capital of parent only
9. Include parents reserves and % share of any post acquisition retained earnings in the subsidiary (unlikely)
10. Calculate Minority Interest
Minorities % share of Net Worth of sub (at FMV IAS, at book value US GAAP)
11. Total Balance Sheet
X
(X)
X
•Control of subsidiaries decisions: Operating/Financing/Investing
•Share ownership > 50%
•Reflect control not ownership
79Goodwill
Business Combination – with Less 100% Interests
Allowed in both US GAAP and IFRS
= consideration / % of interests acquired – fair value of net assets
MI is stated (% of MI shareholders own) (consideration / % of interests acquired)
Full goodwill
Only allowed under IFRS
= consideration – fair value of net assets X % of interests acquired
MI is stated (% of MI shareholders own) X FV of net assets
Partial goodwill
80Business CombinationsPurchase Method Pooling of Interests Method
US: no longer permitted (since 2001)
IAS: no longer permitted (since 2003)
US: required under SFAS 141 – Business Combinations
IAS: required under IFRS 3 –Business Combinations
Treats transaction as acquisition of target by buyer
Treats transaction as merger of equals
Still studied, as move from pooling to purchase has been prospective, not retrospective
No goodwill
No minority interest
No fair value adjustment
Restate prior periods
Post and pre acquisition earnings pooled
Combine equity
Goodwill on consolidation
Purchase consideration 10
% FMV (assets – liabilities) (8)
Goodwill 2
Goodwill
Minority Interests
Fair value adjustments
Post acquisition earnings
81Impact on AccountsCost vs.. Equity
� If sub earnings > 0 and sub dividend payout < 100%, parent results are more favorable under equity method:
� Parent earnings larger
� Parent cash flows the same
� Interest coverage and return on investment ratios higher
� Capital ratios lower
� Cost method preferred if sub is not profitable
� Assets and liabilities are different, but equity is the same
� Revenues and expenses are different (operating income), but net income is the same
� Reported cash flows are different
� Equity method includes only capital flows between parent and sub
� Consolidation method includes all cash flows except between parent and sub
� Financial ratios different
Consolidation vs. Equity
Proportionate Consolidation vs. Equity Method� Equity, net income and ROE are the same under both methods
� Most other accounts and ratios change
� Equity method overstates ROA
� Equity method hides liabilities
� Equity method hides footnote info
82
Purchase vs.. Proportionate vs. Equity A/C
� Current RatioConsolidated > Proportionate > EquityAssuming investee ratio > parents
� LeverageConsolidated > Proportionate > Equity
� Net Profit MarginEquity > Proportionate > Consolidated
� Gross MarginConsolidated > Proportionate > EquityAssuming investee ratio > parents
� Return on Assets ROAEquity > Proportionate > Consolidated
Impact on Accounts
Purchase vs. Pooling� Assets
Purchase > Pooling� Equity
Purchase > PoolingAssuming purchase is funded by issuing equity Net IncomePurchase < Pooling
� Profit MarginsPurchase < Pooling
� ROA and ROEPurchase < Pooling
83
Impairment of goodwillIdentification:
Measurement:
Group Accounting
Carrying value of reporting unit +
goodwill
Fair value of reporting unit>
Carrying value of goodwill
Implied fair value of goodwill>
Fair value of reporting unit –fair value of identifiable net assets
Bargain Purchase (-ve goodwill)
Price < % FMV of identifiable net assets
Reassess FMV of identifiable net assets
US GAAP- reduce non current assets
- take remainder to I/S as an extraordinary gain
IAS - take as gain to I/S
US GAAP & IFRS Differences
In-process R&D
Contingent liabilities
Contingent consideration
Convergence ProjectFMV adjustments for 100% of net assets not just purchased elementMinority interest calculated using FMVIn-process R&D capitalizedContingent consideration recognized at acquisition dateMinority interests in equityRemaining Differences:US GAAP full goodwillIFRS full or partial goodwill
84Special Purpose EntitiesA separate legal entity established by asset transfer to carry out some specific purpose
Uses Access capital or manage risk
Characteri-stics
Issue
Securitized loans, synthetic leases, sale of accounts receivable, R&D costs
Thinly capitalized, lack of independent management, servicing agreements
Prior to Fin 46R consolidation was based on voting rights not risk and reward of ownership
Purpose
VIE Criteria Fin 46R1. Equity interest less than
10% of total assets2. Equity investor lacks:
• Decision making ability• Obligation to absorb
losses• Right to receive
residual returnsA VIE must be consolidated in a company’s accounts if the company is the primary beneficiary (Previously only if controlled via voting rights)
Variable Interests:Guarantees of debtSubordinated debt instrumentsLease residual interest guaranteesParticipation rightsAsset purchase options
Qualifying SPEs US GAAP only
Not consolidated if SPE:•Independent and legal separate from sponsor•Has total control over asset•May only hold financial assets•Sponsor must have limited financial risk
85Pension Plans
Employee directs investment policy
Employer will appoint an investment manager
Asset manageme
nt
Employee owns assets, employer acts as agent
Employer owns assetsAsset
ownership
Employee carries the risk
Employer carries the riskRisk
DefinedContributionDefined Benefit
Income Statement = Employer Contribution
Balance Sheet - Asset/Liability = excess or shortfall in payments relative to specified contribution level
No major analyst issues
Income Statement = Pension expense
Balance Sheet - Asset/Liability = Cumulative payments into plan less cumulative pension expense SFAS 87 & IAS19Post 2006 SFAS 158 Asset/Liability = Funded status
Major issue for analysts
PBO (Projected Benefit Obligation)Present value of all future pension payments earned to date based on expected salary increases over time. Assumes employee works until retirement. Estimate of liability on a going concern basisABO = Accumulated Benefit ObligationVBO = Vested Benefit Obligation
86Pensions
Service cost
Interest cost
Actuarial gains or losses
Prior service cost
Benefits paid
ENDING PBO
-/+
-/+
+
+
=
BEGINNING PBOX
-
Reconciliation disclosed in foot notes (SFAS 132)
Benefits paid to retirees
Fair value of plan assets at end of year
Fair value of plan assets at start of year
Actual return on plan assets
Employer contributions
Plan participant contributions
Expenses
X
+
+
+
-
=
-
Reconciliation disclosed in foot notes (SFAS 132)
87Pensions
Actual Events
Service Cost
Interest Cost
Smoothed Events (SFAS 87)Expected Return on Plan AssetsAmortisation of gains/lossesAmortisation of prior service costsAmortisation of transition asset or liability
+
+
-
+/-
+/-
+/-
Reported Pension Cost X
Other EventsCurtailment/Settlements/ Termination
+/-
Pension Expense FV of Plan Assets – PBO = Funded Status
FV > PBO = Overfunded
FV < PBO = Underfunded
Funded Status = Economic Position of Plan
Funded Status B/S Asset/Liability SFAS 158
Funded Status
Actuarial (Gain)/Loss
Prior Service Cost
Net Transition Asset
Balance Sheet (Liability)/Asset
+/-
+/-
+/-
+/-
+/-
88Actuarial Assumptions
LowerLowerLowerPension Expense
No changeNo changeLowerABO
No changeLowerLowerPBO
Higher Expected Return on Assets
Lower wage rate
increases
Higher discount rate
ActuarialAssumptions
3 main delayed events� Actuarial gains & losses� Prior service adjustments� Transition assets & liabilities
Net of:
Plan Assets
Actual vs.. Expected return
Plan Liabilities
� PBO due to � actuarial assumptionsAmortised if net gain or loss > 10% of opening PBO or Market related plan assets value
Delayed Events
89Post 2006 SFAS 158
SFAS 158 Impact on Financial Statements� Income Statement same as SFAS 87� Balance Sheet = Funded Status
Adjust balance sheet asset/liability to funded statusAdjust deferred tax assetAdjust comprehensive income (equity)
� Assuming net actuarial losses the new standard will increase the pension liability and reduce equity
90
Income Statement:Adjusted pension expense = service cost + interest cost – actual return on plan assetsAlternatively = � funded status + employer contributionImprovement in funded position reduced economic expenseWorsening of funded position increases economic expenseRequired for both SFAS 87 and 158
Analyzing Pension Disclosures
Balance Sheet:Replace accounting asset/liability with funded status take any change to equityNB only required for SFAS 87 not 158
Cash Flow Statement
Cash flow = employer contribution into fund ( CFO)
Contribution > Economic Expense = Principal repayment CFF CFO
Contribution < Economic Expense = Source of funding CFF CFO
Analyst should adjust CFO and CFF for after tax amounts
Analyst Adjustment
91Employee Compensation
Employee compensation:� Salary� Bonus� Share based compensation
Managerial compensation disclosure:� US GAAP - Proxy statement to SEC� IAS – Accounting disclosure
Share based compensation
Advantages:
Reduces agency problem
No cash outlay
Disadvantages:
Dilution of EPS
Employees limited influence over share price
ownership risk aversion
Stock options risk taking
Dilution of existing shareholders
Stock Based Appreciation Rights
Payments linked to share value performance
No shares held
Advantages:
Avoids dilution
Avoids risk aversion
Disadvantages:
Cash outflows
Expense spread over service life
92Stock Compensation PlansStock Options� Prior to June 2005
� Account APB 25� Footnote Disclosure SFAS 123
� Post June 2005� Account SFAS 123
APB 25 Intrinsic value at grant dateSFAS 123 Fair value at grant date
(similar to IFRS 2)
DisclosureNature and extent of arrangementMethod of determining fair valueImpact on periods income
Fair valueMarket premium of similar option orvaluation model:
BSMBinomialMonte Carlo
Stock Purchase PlansEnable employees to purchase stock at a discount to market valueRecognize expense over life of option if compensatory (5% rule)Service Based AwardsCompensation linked to length of serviceRecognize expense over vesting periodPerformance Based AwardsNon price related and price relatedRecognize over estimated time to meet criteriaCan lead to accounting manipulation
All models require 6 inputs:1. Exercise price2. Stock price at grant date3. Volatility4. Risk free rate5. Expected term (time to expiry)6. Dividends
93Foreign Currency TranslationFunctional currency Reporting currencyLocal currencyThe currency of the primary economic environment in which the firm generates and expends cash flows.
The currency in which the multi-national firm prepares its final, consolidated financial statements. For exam purposes, most likely to be the US$
The currency of the country in which the foreign subsidiary is located
Temporal method of translationaka “Remeasurement”
Current Rate method of translationaka “Translation”
SFAS 52 Hyperinflation = cumulative 3 year inflation rate > 100%Use temporal method – prevents book value of PP&E falling
Net asset position and depreciating local currency - reduces $ value of net assets � negative translation adjustment under
current rate method
Temporal method if amount of liabilities exposed to current rate exceeds exposed assets – (net liability position) a depreciating currency makes this liability smaller
94Temporal/RemeasurementLiabilities (current)
Common Stock (historic)
Retained earnings (ß)
Liabilities + Equity
X
X
X
X
Temporal
1. Produce top of Balance Sheet (Total Assets)
2. Produce Shareholders Funds and Liabilities (retained earnings = plug figure to ensure that the balance sheet balances)
3. Produce reconciliation of retained earnings
4. Net Income in the Income Statement will be different from NI in retained earnings. The difference is the exchange gain/(loss) which is taken to the income statement
Opening retained earnings
Net income (ß)
Dividends
Closing Retained earnings
X
X
(X)
X
SFAS 52 Hyperinflation = use TemporalIAS 21 Hyperinflation = use indexing
Monetary assets/liabilities = current rates (cash, AR, AP, STD,LTD)
Non monetary assets/liabilities = historic rates
95Current/Translation
All Current Approach
1. Produce Income Statement – translating at average rate
2. Derive closing retained earnings
3. Compute Balance Sheet
4. Top and bottom of the balance sheet will not balance. The difference is the translation gain/(loss)
5. Force the balance sheet to balance by including the adjustment on the balance sheet in the equity section
Opening retained earnings
NI (from income statement)
Dividends
Closing Retained earnings
X
X
(X)
X
All assets/liabilities = current rates
96Impact on RatiosTranslation/All Current (Compared to LC)� No change from translation using all-
current method for pure income statement and balance sheet ratios
� Mixed ratios are distorted� FX rate changes affect consolidated ratios,
even when no “real” change occurs
Comparing Temporal and All Current� Process:
� Step 1: LC appreciating or depreciating?� Step 2: Examine numerator
� Translated at which rate? (current, avg, historic, etc.)
� Will numerator be larger or smaller?� Step 3: Examine denominator
� Same as numerator� Step 4: Determine impact on ratio
Remeasurement/Temporal (Compared to LC)
� Even pure ratios may be distorted due to mix of current and historic in B/S or average and historic in I/S
� Mixed ratios now a blend of current, average and historic!
97IAS & Transaction RiskIAS 21 Similar to SFAS 52Exceptions
� Integral subsidiaries – temporal method� Foreign entities – all current� Revaluations – historic rate at time of revaluation� Hyperinflation – indexing� Goodwill – current or historic rate � Losses resulting from the acquisition of an asset invoiced in an overseas
currency can be expensed (SFAS 52) or added to capitalized cost
Transaction Gains/(Losses)
Transaction recorded at spot rate
Receipt or payment at a later date
Issue = movements in spot rate between entering and settling a contract
Gains and losses reported in income statement (no guidance to where)
• Within SGA
• Non-operating income/expense
reduces comparability
98The Lessons & DerivativesThe lessons we learn1. Read all info including MDA and Footnotes2. Be sceptical – persistently higher than average growth rates3. Understand what you are looking at: pro-forma information4. Follow the money (cash flow and earnings divergence)5. Understand the risks (business & financial)
Derivative Accounting
B/S fair value
Speculatively held – gains/losses I/S
Hedging purposes – location per SFAS 133
Fair Value Hedge
Hedging asset/liability value
Gains and losses I/S
Cash flow hedge
Hedging the future cash flows of a transaction
Unrealized gains/losses to comprehensive income
Accumulated gains/losses released to I/S when the transaction affects earnings
Hedging foreign currency exposure
All current – gains/losses to comprehensive income
Temporal - gains/losses to I/S
99Financial Reporting QualityAccrual vs.. Cash Accounting
Cash:
Transaction recorded on payment/receipt
Advantages: No subjectivity/Easy to verify
Accrual:
Revenue/Expense triggered by earnings process
Advantages: Timely and relevant information/Indication of value creating activities
Disadvantages: Subjective measurement/earnings management
1. Revenue Recognition:• % completion method• Earnings activities
complete• Assurance of receipt• Bill and hold• Unearned income
2. Depreciation Choices:• Method (S/L vs accel’)• UEL• Salvage value
3. Inventory Choices• FIFO/LIFO/AVCO• Normal cost• LOCOM rules
4. Goodwill• Fair value measurement• Impairments
5. Deferred Tax• Valuation allowance
6. Pension Accounting• Discount rate• Expected returns• Salary growth
7. Assets held at FMV8. Stock Options9. Provisions
100Financial Reporting QualityManipulation Incentives:
Analyst Expectations
Remuneration (Bonus/Stock Option)
Debt Covenants
Financing (raising further funds)
Disciplining Mechanisms:
External Auditors
Internal Audit/Committee
Management Certification
Class Action Law Suits
Regulators
Market ScrutinyEarnings:
Quality = persistence/sustainability
Mean reversion
Cash flow and accruals elements
Accruals element – not sustainable
Accruals – naturally self correct
Richardson, Tuna, Wu – companies restating earnings have highest accruals
Calculations:
Aggregate Accruals
Accrual based earnings NI
Cash based earnings
= -
Net Operating
Assets NOA
Total assets -cash
Total liabilities –total debt
= -
Aggregate Accruals
NOAt NOAt-1= -
Aggregate Accruals
NI – (CFOt + CFIt)= -
B/S based aggregate accruals
Cash flow based aggregate accruals
101Earnings ManagementRevenue Recognition Problems:Range of problems:Recognition of sale before completion of earnings processRecognition of sale without assurance of receiptEstimates:Credit salesDeferred/Unearned revenueWarranty provisionsSales returnsWarning Signs:Large ARLarge Unearned RevenueLower future cash-flows and accounting rates of return
Accelerating Revenue RecognitionRange of problems:Recognition of sale before completion of
earnings process (assessing the completion date)
Lowering credit standardsCut off issues (moving sales between periods)Warning signs:Bundled productsManagement vested options ITMPressure to meet earnings forecastsRaising additional financeLarge ARLarge Unearned RevenueDisproportionate revenue in last ¼
Recognizing revenue to early:Bill-and-hold salesLessor use of sales type vs.. direct financing leasesRecording sales prior to acceptance by customer (sales of equipment prior to installation)Incorrectly using % completion method for long term contracts
102Earnings ManagementClassification of non operating earnings as operating:Range of problems:1.Investment income2.Divestiture of non current assetsNB. No accrual or deferral reversal in later periodsWarning signs:Temporary inconsistency of items included within definition of operating income
Expense Recognition:Range of problems:Discretion over depreciation and amortizationImpairment recognitionApplication of lower of cost and fair value
rulesWarning signs:
of methods or lives – depreciation (disclosed in footnotes)
Conference calls – additional informationLIFO liquidationsInventory obsolescence
Deferring Expenses:Range of problems:Capitalization of operating expensesWarning signs:
Net non current assets (B/S broad measure accruals)Consider asset growth in the context of expected sales and margin growthSoftware development costs - discretion
Classification of operating expenses as non operatingRange of problems:Incorrect classification reduces COGS or SG&AWarning signs:Company’s with genuine special items that can be piggy backedChanges in operating profit margin or gross margin accompanied by spikes in special items
103Earnings ManagementBig Bath ProvisionsRange of problems:1. Impairments – future I/S
improvements via depreciation2. Restructuring or impairment charges
reversed in subsequent periods3. Use of high or low bad debt reserves
out of line with peers
Off Balance Sheet ItemsRange of problems:1.Assets and liabilities avoiding recognition:
Operating leases Sale of AR with recourseTake or pay/through put agreementsEquity accounted SPVs
Warning signs:SEC obligations to report future cash flow obligations of operating leases – analyst may discount to PV and restate
Goodwill:Range of problemsFMV adjustments on acquisitionFuture impairments
Warning signs:Goodwill reported and not impaired forcompanies where market cap < book value
IASB & FASB move to fair value accountingIssues:Some assets have readily identified fair values
e.g. listed equitySome assets don’t have readily identified fair values (assets with no actively traded secondary markets)
e.g. unlisted equitye.g. specialized equipment
Valuation models = discretionary inputs
104Modifying the Balance Sheet
� Unrecorded Items� Special Purpose Entities � Operating Leases� Guarantees� Contingent liabilities
� Recorded Items� Marketable securities� Accounts receivable� Inventory� Proportional vs.. equity a/c� Property Plant and Equipment� Capitalized interest� Goodwill� Intangibles (R&D)� Redeemable Pref/Convertible Debt� Long term debt� Pension Liabilities (SFAS 87!)� Stock Option plans (Pre SFAS 123R)� Deferred Income Taxes
Comprehensive IncomeNet IncomePension adjustmentsUnrealised gains and losses on available for sale securitiesCumulative foreign currency translation adjustmentsComprehensive Income
$XX
X
XX
US G
AAP
COGS LIFO – FIFOCapitalization of operating leasesReversal of deferred tax assets/liabilitiesMark to market LTD
Adjustments (not required by US GAAP)Capitalized interest reversalOff Balance sheet itemsFunded status of pension plan
105
� Adjust COGs to LIFO� Litigation or gov’t actions� Discontinued ops� LIFO liquidations� Capitalize Op leases� Capitalized interest� Economic cost of pension
plan� Temporal gains/(losses)
Normalized Earnings� Normalizing Operating Earnings
� Discretionary accounting changes� Regulated accounting changes� Realised capital gains/losses� Gains/losses on repurchase of debt� Catastrophes� Insurance settlements� Strikes� Impairment or restructuring
Inter-firm comparisons (adjustments)
Inventory methods
Depreciation assumptions/methods
Pension plan/Stock option assumptions
Capital/operating leases
Cyclical FirmsRemove the impact for
valuation:1. Averages over the
business cycle2. Average ratios applies
to current sales or equity
3. Regression model approach
Internationalcomparisons
LIFO prohibitions
Extraordinary items
Capitalized R&D
Accelerate Depn
Asset revaluation
Acquisition a/c
106
Corporate FinanceStudy Sessions 8 – 9
Weighting 5% – 15%
107Overview of Level II Corp Fin
Capital Budgeting
Study Session 8
Capital Structure and Leverage
Corporate Governance
Study Session 9
Mergers and Acquisitions
Dividends and Dividends Policy
108Capital Budgeting (1)
Expansion vs. replacement (see
next slide)� Expansion –
investment to increase the business
� Replacement –replacement of existing equipment with newer alternatives
Inflation and capital budgeting� Real (or nominal) CF
discounted using real discount rate (or nominal)
� Inflation increases company’s real taxes
� Higher than anticipated inflation decreases the worth of interest payments to bondholders
� Inflation does not affect sales and expenses equally
� Use cash not accounting profit� Incremental cash flows only
– Ignore sunk costs– Use opportunity costs–Include net working capital increases/decreases
� Cash flows based on opportunity costs� Cash flow timing is important (time value of money)� Analyze after-tax cash flows� Financing costs reflected in required return
Depreciation methods and cash flows
� Accelerated methods provide higher tax savings and hence better cash flows in the earlier years compared to straight line methods
� Example of accelerated method – MACRS
Comparing projects with unequal lives
� Least common multiple of lives approach – look at NPVs over a common life
� Equivalent Annual Annuity – find the annuity (PMT) that equates the NPVs at the cost of capital
109Expansion vs. replacement projects
Expansion Projects – investment to increase the business
1. Initial cash outflow = FCInv + NWCInv
2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax rate) + Depn
3. Terminal year non-operating cash flow = Cash proceeds from sale of FCInv + NWCInv – tax rate x (Cash proceeds – BV of FCInv Termination)
Replacement projects – replacement of existing equipment with newer alternatives
1. Initial cash outflow = FCInv + NWCInv – Cash proceeds of old asset + tax rate x (Cash proceeds – book value of old asset)
2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax rate) + Depn
3. Terminal year non-operating cash flow = (Cash proceeds from sale of FCInv + NWCInv– tax rate x (Cash proceeds – BV of FCInv Termination)
110
Stand-alone – the project’s individual risk
� Sensitivity to e.g. assumed sales
� Best/worst scenario analysis
� Monte Carlo simulation– random lots of scenarios– generate probability distribution for NPV and IRR
Capital rationing� Management constraint
on the size of the capital budget
� Optimal choice is to select investments that maximize the overall NPV within the capital budget
Using SML in Capital budgeting (Based on )Kproject required return = KRF + (Kmkt – KRF) project
� Kproject required return = discount rate to discount project cash flow
� Use of project beta to calculate required return when project risk is different from the company
Real Options� Real options are options that allow managers to make
decisions at a later date where these decisions are dependent upon future events or information
� Examples: Timing options; sizing options; flexibility options and fundamental options
� Real option analysis� Work out the NPV without including the real options.
If the NPV is positive, accept the project. There is no need to consider the real options if these options enhance the project value.
� Work out the NPV based on estimated future cash flows. Then add the value of the real options. This approach is useful when the NPV is negative.
Capital Budgeting (2)
111Capital Budgeting (3)Economic versus accounting incomeEconomic income = cash flow + change in market value NB: Change in MV = Ending MV – Beginning MVorEconomic income = cash flow – economic depreciation
Accounting income differs from economic income in the following ways:� Accounting depreciation is based on initial cost of the investment and reflects the decline
in the book value. Economic depreciation reflects the decline in the market value of the investment.
� Interest expense is included in accounting income but ignored in economic income.
Other valuation models� Economic profit (EP) = NOPAT - $WACC = EBIT(1 – t) – [WACC x Capital]
� NPV = MVA = sum of PV of all future EPs discounted at WACC� Residual income: RIt = NIt – reBt-1
� NPV = sum of PV of all future RIs discounted at cost of equity� Claims valuation – looks at the cash flows to debt holders and equity holders. The sum of
the PV of these cash flows equal project NPV
112Capital structure� Objective of capital structure decision is to maximise firm value and minimises the WACC
Taxes and its impact on value of the firm & re� Interest are tax deductible, debt capital provides a
tax shield that increases the value of a company.� Proposition I (with taxes): value is maximised at
100% debt�Value of a leveraged firm = value of an
ungeared firm + value of the tax shield� Proposition II (with taxes): WACC is minimised at
100% debt� With tax, WACC is
� Cost of equity is
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MM Proposition without taxes� Proposition I: Capital structure
decision does not affect the company’s market value
� MM assumed no taxes and no cost of bankruptcy
� Value of ungeared firm = value of a leveraged firm
� Proposition II: The cost of equity is linearly related to the firm’s debt to equity ratio�Without taxes, WACC is
�Cost of equity is�As D/E increases, cost of equity
would increase
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MM no taxD/E
Cos
t of c
apita
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rdWACC
re
MM with taxes
113Debt financing: other issues (1)In reality, the value of a leveraged firm is affected by factors other than the interest on the debt. These factors are:
Agency costs� Agency costs of equity – conflicts
between equity owners and managers who managed the company.
� The net agency costs of equity include:� Monitoring cost – incurred by
shareholders to supervise the managers.
� Bonding costs – incurred by management to assure shareholders that they are working for shareholders’ interests.
� Residual loss – incurred even though there is monitoring and bonding systems in place as these systems are not flawless
� Theory says that if a firm uses more debt, it would reduce the net agency costs of equity.
Financial distress costs
� Costs of financial distress and bankruptcy can be direct or indirect costs.
� Probability of bankruptcyHigher operating or financial leverage leads to higher probability of financial distress
Cost of asymmetric information
� Managers of the firm have better information compared to outsiders.
� Valuation implications:Stock offering �negative signal Debt offering � positivesignal
� Pecking order theory says that mangers choose financing methods that are the least observable signals to the most apparent signals. Manager prefers to use internally generated funds, then debt and finally equity.
114Static trade-off theory� Under the static trade-off theory, as
higher proportion of debt is being used, there exist a point where the benefit arising from the use of debt (i.e. tax shield) is offset by the costs of financial distress.
� An optimal capital structure exists where the value of the firm is maximized.
� The optimal capital structure is a function of many factors
Vungeared
VLeveraged
Max firm value
MV
of firm
Debt ratio
Optimal Debt ratio
PV tax shields
Cost of financial distress
Cost of capital
Optimal D/E ratio
D/E ratio
rd
WACC
re
Between 0% and 100%
Implications for managers’ decisions� MM I (No Taxes): Capital structure
irrelevant� MM I (With Taxes): 100% debt maximizes
value� Pecking order theory: Capital structure is
by-product of individual financing choices� Static trade-off theory: Trade off cheaper
debt financing with costs of financial distress; optimal capital structure between 0% and 100%
115Debt financing: other issues (2)Target Capital Structure� Used when making decisions on raising new finance� For managers maximizing firm value target = optimal
capital structure� Practice – fluctuation around target:
� Exploitation of opportunities in a specific financing source
� Fluctuating debt/equity markets affecting weightings
Capital Structure and ValuationAnalyst considerations:� Changes in capital structure over
time� Capital structure of competitors
with similar business risk� Factors effecting agency cost –
corporate governance
International Difference in Leverage� Japan/France more debt than US/UK� Debt maturity – longer in US than Japan� Developed markets have more total debt
and longer maturity than emerging markets
Institutional/Legal Factors• Strength of legal system• Information asymmetry• Taxes
Financial Markets/Banking System
• Liquidity• Reliance on banking system• Institutional Investor presence
MacroeconomicFactors
• Inflation• GDP growth
Debt Rating Agencies� Cost of capital tied to debt ratings� Goals for achieving certain ratings may
effect capital structure
116Dividends and dividend policy (1)Factors affecting dividend payout policy� Taxation of dividends� Flotation costs of a new issue� Restrictions on dividend payments� Signalling effects� Clientele effects
Taxation of dividends:Double taxation and split rate systems:� Effective tax rate
= corporate tax + (1 – corp tax) x individual tax� Split tax rate – use corporate tax rate for
distributed income� Imputation system – div taxed only at
shareholders’ rate
Signalling effect:• Dividend initiation – mixed view• Unanticipated dividend increase –
signal strong future prospects• Unanticipated dividend decrease –
negative signal
Residual dividend model� Dividend = actual earnings
minus the equity portion of firm’s capital budget
� Advantages: simple to use; investment opportunities considered independent of the dividend
� Disadvantages: unstable dividend payments; uncertainty as to dividend increases investors assessment of risk
117Dividends and dividend policy (2)
Pay a specific % of total earnings over long-term
Focus on steady $ payout –even though earnings may be volatileIn practice this increases with the long term rate of growth of the company
Longer term forecast of capital budget is determined –excess earnings over this period are then spread more evenly each year
Easy to useBUTInvestors may prefer stable dividends
Targetpayout ratio
Dividendstability
Longer-termresidualdividend
ResidualDividend
Dividend using the target payout approach:� �� � � �
� � � �� �� � � �� �� � � �� �� � � �� � � �� � � ��
expected target previous adjustmentexpected dividend = + increase payout dividend factorin EPS ratio
118Dividends and dividend policy (3)
� Investors will prefer NOT to receive dividends due to their higher tax rates.
� Low dividend payout policy will be rewarded.
� Evidence shows Ks decreases as payout ratio increases –investors are rewarding the certainty of near term dividends with a lower level of risk.
� Higher dividend payout policy will be rewarded.
� Dividends can be manufactured – sell a little bit of stock to get the cash you want.
� Theory requires a number of assumptions.
� Policy has NO effect on value.
The tax aversion theoryThe bird-in-the-hand theoryDividend irrelevance theory
Rationales for stock repurchases� Signal that future outlook is good� Share dilution due to exercise of stock
options� Distribute cash � Company views its own stock as good
investment� Change the capital structure
Dividend initiationBased on dividend preference theory Dividend initiation � Lower risk� Lower cost of equity� Higher PE ratio
119Corporate governance (1)
Definition:The system of principles, policies, procedures and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts inherent in the corporate form” (McEnally and Kim)
Objectives:� Eliminate or reduce conflicts of interest� Use the company’s assets properly
An effective system will:� Define the rights of shareholders (and other important stakeholders)� Define and communicate to stakeholders the oversight responsibilities of
managers and directors� Provide fair and equitable treatment in all dealings between managers,
directors and shareholders� Have complete transparency and accuracy in disclosures regarding
operations, performance, risk, and financial position
120Corporate governance (2)
Corporate shareholders have no input in the day to day mgmt of the firm – this lack of control can create conflict between managers and shareholders
Similar to sole proprietors – conflicts between partners are dealt with by implementing a partnership agreement
Since owners and managers are one in the same no conflict exists here. Conflicts mainly involve creditors and suppliers
Distinct legal entities –managers act as agents of co.
Two or more owner managers
Owned and operated by a single individual
CorporationsPartnershipSole Proprietorship
Managers and shareholdersManagement may act in their best interests not those of the shareholders�Using funds to expand the size of the firm�Granting excessive compensation and perquisites�Investing in risky ventures�Not taking enough risk
Directors and shareholdersDirectors may align more closely with managers than shareholders� Lack of independence� Board members with personal relationships
with managers� Board members having consulting or other
business agreements with the firm� Interlinked boards� Directors are over compensated
Agency Relationships
Conflicts of Interest
121Corporate governance (3)
Determining the effectiveness of the Board
� Composition of board: 75% of directors independent� Independent chairman on board (not CEO)� Qualifications of directors� How board elected (annual elections)� Board self-assessment practices� Frequency of separate sessions for independent directors (annually)� Audit committee and audit oversight (only independent directors)� Nominating committee (only independent directors)� Compensation committee and management compensation (mostly performance-based)� Use of independent and expert legal counsel� Statement of governance policies� Disclosure and transparency (more disclosure is better)� Insider or related-party transactions (board approval for related-party transactions)� Responsiveness to shareholder proxy votes
122Corporate governance (4)Board Of DirectorsThe board of directors have a responsibility to:� Institute corporate values� Ensure firm complies with all legal and regulatory requirements� Create long term strategic objectives� Determine management’s responsibilities� Evaluate the performance of the CEO� Require management to supply the board with complete and accurate information� Meet regularly� Ensure board members are adequately trained
Investors and analysts should assess the following policies of corporate governance:� Codes of ethics� Directors’ oversight, monitoring and review
responsibilities� Management’s responsibility to the board� Reports of directors’ oversight and review of
management� Board self-assessments� Management performance assessments� Directors’ training
Corporate Governance and Company Value
� Firms with strong/effective governance systems exhibit:
Higher measures of profitabilityHigher returns for shareholders
� Weak/ineffective governance system:Increased risk to investorsReduced valueExtreme cases: bankruptcy
123Mergers and acquisitions� Acquisition: One company buys only part of
another company� Merger: One company absorbs another
company entirely
Forms of integration� Statutory merger: target company ceases to
exist� Subsidiary merger: target company becomes a
subsidiary of the acquirer� Consolidation: acquirer and target form a
completely new company
Types of Merger
Acquirer
Forward integration
Horizontal
Conglomerate
Brewery Another Brewery
Pubs
Training
Hops Farms
Merger motivations� Synergies� Achieving more rapid growth� Increased market power� Gaining access to unique capabilities� Diversification� Bootstrapping� Personal benefits for managers� Tax benefits� Unlocking hidden values� Achieving international business goals
Bootstrapping EPS� A way of packaging earnings from
two companies after a merger� Increase in earnings per share� Real economic gains are not
necessarily achieved� Occurs when a firm with a high P/E
ratio acquires a firm with a low P/E ratio
Backward integration
124Industry life cycle and common mergers� Mature growth phase:
~ Industry characteristics: reduced profit margins due to new competition, but potential still exists for above average growth
~ Merger motivation: efficiency, economies of scale/synergies
~ Horizontal and vertical� Stabilization phase:
~ Industry characteristics: competition has reduced most of industry’s growth potential
~ Merger motivation: economies of scale, reduced costs, improve management
~ Horizontal� Decline phase:
~ Industry characteristics: declining profit margins, overcapacity, and lower demand due to shifts in consumer tastes
~ Merger motivation: survival, operating efficiencies, new growth opportunities
~ Horizontal, vertical, and conglomerate
� Pioneer/development phase: ~ Industry characteristics:
uncertain of product acceptance, low profit margins, and large capital requirements
~ Merger motivation: access to capital, management talent
~ conglomerate and horizontal
� Rapid growth phase:~ Industry characteristics: high
profit margins, accelerating sales, and earnings, but still low industry competition
~ Merger motivation: access to capital, expand growth capacity
~ conglomerate and horizontal
125Mergers transaction characteristicsComparing Forms of Acquisition
Friendly merger offersAcquirer approaches management
Negotiations and due diligence
Definitive merger agreement
Public announcement and shareholders vote
Attitude of target management
Usually avoids assuming
Acquirer assumes
Liabilities
NoneS/H pay CGS/H taxes
Target pays CGNoneCorporate taxesNone for “small”ShareholdersApproval
To targetTo shareholderPayment
Asset PurchaseStock Purchase
Hostile merger offersAcquirer submits proposal to board of directors
Successful Unsuccessful
Tender offer Proxy battle
Offer made to shareholders Proxy solicitation
126Takeover defense & HHIPre-offer defense mechanisms
� Poison pill: flip-in pill and flip-over pill� Poison put� States with restrictive takeover laws� Staggered board� Restricted voting rights� Supermajority voting provision for mergers� Fair price amendment� Golden parachutes
Post-offer defense mechanisms� “Just say no” defense� Litigation� Greenmail� Share repurchase� Leveraged recapitalization� Crown jewel defense� Pac-man defense� White knight defense� White squire defense
Virtually certain
50 or moreHigh> 1800
Possible100 or moreModerateBetween 1000
& 1800
No actionAny amountNot concentrated< 1000
Antitrust Action
Changein HHI
IndustryConcentration
Post merger HHIHerfindahl-
Hirschman IndexKey measure of market power for determining anti-trust violations
n2
ii=1
HHI = (MS ? 100)
127Valuing a target company (1)
Discounted cash flow method� Similar to FCFF approach in
SS 12� Determine free cash flows
available to investors after necessary expenditures
� Choose appropriate discount rate (target company WACC adjusted for merger effects)
� Discount cash flows back to the present
� Determine terminal value –constant growth or market multiple
Comparable transaction analysis� Also uses relative value metrics
for comparables� Comparables are recent takeover
transactions, not just comparable firms!
� No need to calculate separate takeover premium
3 methods to evaluate a target company
Comparable company analysis
� Uses relative value metrics from similar firms
� Adds a takeover premium to determine fair price to pay
128Valuing a target company (2)
Discounted cash flow method
Advantages� Easy to model changes in
cash flow from synergies� Using forecasts avoids
biases that may exist in current market data
� Model is easy to customizeDisadvantages� Model is difficult to apply
when free cash flows are negative (rapid growth firm)
� Estimation error – terminal value
� Changing discount rates can have large impact on estimate
Comparable transaction analysis
Advantages� No need to estimate a
takeover premium� Estimates of value are
derived directly from recent deal prices
Disadvantages� Assumes past M&A
transactions were accurately valued
� May not be enough comparable transactions available
� Difficult to incorporate synergies or changing capital structures into analysis
3 methods to evaluate a target company
Comparable company analysis
Advantages� Easy access to data� Estimates of value are
derived from the market (reduces estimation error)
Disadvantages� Assumes market is
valuing comparable firms correctly
� Must determine takeover premium separately
� Difficult to incorporate synergies or changing capital structures
� Historical data used to estimate a takeover premium may not be timely
129Evaluating a merger bid� Post-merger value of an acquirer: VAT = VA + VT + S – C� Gains accrued to the target: GainT = TP = PT – VT
� Gains accrued to the acquirer: GainA = S – TP = S – (PT – VT)� Adjustment for stock payment: PT = (N PAT)
where: N = number of new shares target receivesPAT = price per share after merger announced
Effect of PaymentCash offer � Acquirer assumes the risk and receives the potential reward� Gain for target shareholders is limited� If synergies more than expected, takeover premium for target is fixed, so acquirer wins� If synergies less than expected, acquirer losesStock offer� Some of the risks and potential rewards shift to the target firm� Target shareholders will own part of acquiring firm� Confident synergies will be realized
� Acquirer wants to pay cash; target wants stock to participate in upside� Lack of confidence in synergy estimates
� Acquirer wants to pay in stock to share risk; target wants cash to lock in any gains
130Mergers benefits & restructuringDistribution of merger benefits
Short-term effect on stock price� Targets gain approximately 30%� Acquirer’s lose between 1% and 3%
Long-term effect on stock price� Acquirers tend to underperform� Failure to capture promised synergies
Corporate restructuring� Divestitures: Selling, liquidating, or spinning off a division or subsidiary� Equity carve-outs: creates a new, independent company; sell shares to outside
stockholders through a public offering� Spin-offs: create a new, independent company; distribute shares to parent company
shareholders – no cash for parent� Split-offs: existing shareholders must exchange shares for shares of new division � Liquidations: break up the firm and sell its assets piece by piece
Reasons for divestitures� Division no longer fits into
management’s long-term strategy� Lack of profitability� Reverse synergy – individual parts are
worth more than the whole� Infusion of cash
131
Equity Investments Study Sessions 10,11 &12
Weighting 20 -30%
132Equity Investments - Overview
Valuation process
Residual Income Valuation
Market-Based Valuation: Price
Multiples
Free Cash Flow
Valuation
Valuation in Emerging Markets
Return concepts
Industry Analysis
Five competitive forces
Discounted Dividend Valuation
Private Company Valuation
A note on asset
valuation
133
Graham and Dodd 1934 – 1962Value should be independent of price
Financial statement analysis, earnings power, growth prospects
Relative valuation methods
“Blocking and tackling”
A Note on Asset ValuationJohn Burr Williams (1938)
Value is the present value of cash flows at an “opportunity cost of capital”
Discount rate was not clearly defined
DDM and FCF models
Forward-looking
Modern Portfolio Theory (1959)Harry Markowitz (Portfolio Selection):
Value includes growth and risk, efficient frontier dominates other portfolios, covariance is key, diversification is a free lunch
William Sharpe:
Cost of capital is function of systematic, non-diversifiable risk
Unsystematic risk can be diversified away
Developed CAPM
Modern Valuation TechniquesFixed income: PV of coupons and par
value discounted by YTM
Common stock: PV of future cash flows discounted by the required return
DDM: PV of expected dividends
FCFF: discounted at WACC
FCFE: required return on equity
Relative value: earnings multiplierResidual income: current book value +
PV of expected economic profit
134
Uses:• Stock selection• Reading the market• Projecting the value of
corporate actions• Fairness opinions• Planning and
consulting• Communications with
analysts and investors• Valuation of private
business• Portfolio construction
and management
Valuation = the estimation of an asset’s value
Absolute – based on variables perceived to be related to future investment returns
Relative – based on comparisons with similar assets
Inputs – should be qualitative as well as quantitative
Valuation Process -Overview
1. Understand the business2. Forecast business
performance3. Select the relevant
valuation model(s)4. Convert forecasts to a
valuation5. Make the
recommendation or investment decision
Critical step that involves financial statement analysis (including quality of earnings analysis) combined with an evaluation of industry prospects, competitive position and corporate strategies.
Valuation Process
135
Industry Competitive Analysis Five Elements of Industry structure: Threat of new entrants, Threat of substitutes, Bargaining power of Buyers, Bargaining power of Suppliers, Rivalry among Existing Competition
Three Generic Strategies: Cost Leadership, Product Differentiation, Focus
Valuation Process Importance of F/S Footnotes
Footnotes reveal management’s discretion in choices of accounting methods and estimates
Analyst’s ability to accurately forecast result derived from quality inputs
Greater transparency in earnings results in higher stock price—management’s ultimate goal
Accounting ShenanigansAccelerating or Premature Recognition of Income
Reclassifying gains and non-operating income
Expense recognition and losses
Amortization, depreciation, and discount rates
Off-balance sheet issues
Considerations in ValuationFits the Characteristics of the Company (Does it pay dividends? Is earnings growth estimable? Does it has significant intangible assets)
Is appropriate based on the quality and availability of input data
Is suitable given the purpose of the analysis
Considering only one model is not good
136
Perceived mispricing• = any difference between the analyst’s estimate of intrinsic value and the market price
• reflected in the abnormal return, alpha, the analyst expects to earn.
Ex ante alpha = expected holding-period return – required return
Ex post alpha is used to assess the success of the analyst’s strategy= actual holding-period return - contemporaneous required return
Model selected must be:• consistent with the characteristics of the company being valued;• appropriate given the availability and quality of data;• consistent with the purpose of valuation, including the analyst’s ownership
perspective (i.e. extent of the investor’s influence over the company).
Valuation Process
Ownership PerspectiveMarketable publicly traded minority interest—DDM approach is the benchmark value
Premiums for control—FCFE approach
Discounts for lack of marketability for non-publicly traded stocks
Discounts for lack of liquidity for publicly traded stocks
137
Different Returns/Rates• Holding Period Return, Realized Return, Expected Return, Required Return, Return from
Price Convergence, Discount Rate, Internal Rate of Return
Return Concepts
Ways of Measuring the Required Return
• Multifactor Models
Req’d Return=(factor sensitivity)i*(factor risk premium)i + …. + (factor sensitivity)n*(factor risk premium)n
CAPM:
� �� �fmf rrE�rE(r) �� �
“equity risk premium”
138Return Concepts
Ways of Measuring the Required Return
Fama – French Model
Req’d return on stock j = Rf + bmkt,*(Rmkt – Rf) + bSMB,j*(RSMALL-RBIG) + bHML,j*(RHBM-RLBM)
Rmkt – Rf = return on a value weighted market index minus risk free rateRSMALL-RBIG =small cap return premiumRHBM-RLBM =value return premium
Pastor-Stambaugh Model
Builds on the Fama French Model by adding a liquidity factor
Macroeconomic Multifactor Models e.g. Burmeister, Roll and Ross Model
Uses economic variables believed to affect cash flows as factors within the model.
139Return ConceptsWays of Measuring the Required Return
Build-Up Method
Req’d return =Rf + Equity risk premium + size premiuim + specific company premium
Bond Yield Plus Risk Premium
Req’d return =YTM on long term debt + risk premium
Country Spread Model and Country Risk Rating Model
Calculates the premium to be added to the req’d return when investing in emerging mkts
140Return ConceptsEstimating Beta
Public Companies
Use regression of company stock returns against the market
Adjust for beta drift by using adjusted beta
Adjusted beta=(2/3)*regression beta + (1/3)*1
Thinly traded/non public companies
Estimated beta for ABC=unlevered beta of similar quoted company *
(1+(debt of ABC/equity of ABC))
Unlevered beta of similar quoted company = Beta of similar co.*
1/[1+(debt of similar co/equity of similar co)]
141Return Concepts
Estimating Equity Risk Premium using…..
Historical estimatesStrengths:•Objective. Simple, unbiased if investors rationalWeaknesses:•Assumes mean and variance are stationary•Different ways of calculating mean return (geometric, arithmetic)•Different ways of estimating risk free rate (can use long or short term bonds)
142Return ConceptsEstimating Equity Risk Premium using…..
Forward looking / Ex Ante estimatesStrengths:•Doesn’t depend on assumption of stationarity3 Types…..
Gordons Growth ModelStrengthsAssumptions used are
reasonable and inputs to the model can easily be sourced
Weaknesses• This estimate will change
over time and needs updating, assumes stable growth
Supply Side EstimatesStrengths:• Uses proven models
and current informationWeaknesses:• Only appropriate for
developed countries
Survey EstimatesStrengths:• Uses expert opinions
and more likely to be reliable
Weaknesses• There maybe large
differences of opinion
143
Porter’s 5 forces
Top-down forecasting1. Macroeconomic
2. Industry
3. Company
Understanding the business• How attractive are the industries in which the
company operates, in terms of offering prospects for sustained profitability?
• What is the company’s relative competitive position within its industry?
• What is the company’s competitive strategy?
3.
2.
1.
FIRMRIVALRYSUPPLIERS BUYERS
SUBSTITUTES
Bargainingpower Threat of substitute
products or services
Threat ofnew entrants Bargaining
power
POTENTIAL ENTRANTS
Industry and Company Analysis
144
Risks of each generic strategyCost Leadership• New entrant enters market with lower cost base and/or technological breakthrough
reduces rivals production costDifferentiator• Consumers cease to value differentiating factor and/or rival company does it betterNiche• Interest in niche from big players and/or smaller players target sub-sectors of niche
CostLeadership
Differentiation
Narrow TargetBroad Target Focus
CompetitiveAdvantage
Low costs in all market segments• economies of scale• proprietary technology• pref. access to raw materials
Satisfy particular consumer needs
• product/delivery/marketing • premium pricing
A focuser will be an above average performer if it can achieve product differentiation in its chosen sub-sector
A focuser will be an above average performer if it can achieve cost leadership in its chosen sub-sector
Competitive Strategies
145
Industry life cycle
Industry life cycle phasesPioneer - Acceptance of the product or service uncertain, implementation of business strategy is unclear. Period of high risk with many failures.
Growth – Acceptance of the product or service established. Accelerating sales and earnings. Industry growth faster than the general economy. Profit margins above average.
Mature – Industry growth corresponds to the growth of the general economy. Participants compete for share in stable industry.
Decline – Demand for the industry’s product steadily decreases due to shifting tastes or technologies. Profit margins are diminished.
Classification by business cycle reaction• Growth Industry Stocks - experience
accelerating sales and high profit margins during all phases of the business cycle
• Defensive Industry Stocks - product demand independent of the business cycle, therefore less cyclical than the overall market
• Cyclical Industry Stocks - product demand tends to vary directly with the business cycle
Sal
es
Time
Growth Maturity DeclinePioneer
Business and Industry Life Cycles
146
Industry External Factors• Technology • Government• Social changes• Demographics• Foreign influences
Supply analysis• In the long term, demand will equate to supply
• In the short term, there could be shortfalls in supply due to long lead times etc
Demand analysisAn analyst is in a position to assess future demand for the industry’s output by developing• A macroeconomic forecast• An industry classification• An external factor review
Two additional sources of information• A study of the firm’s customers• A study of the industry’s inputs and
outputs
Factors influencing pricing practices and hence profitability• Product segmentation - Firm’s ability to differentiate its product over various market
segments.• Concentration – The greater the concentration, the greater the likelihood of collusion.• Ease of industry entry – Greater ease of entry � prices toward the marginal cost.• Supply input price – Changes in resource prices will have major implications of profitability.
Industry Analysis
147
Dealing with inflation in emerging market valuation
Country Risk Premium
•No satisfactory method for estimation
•Premium is often overstated
Real valuation approach
Nominal valuation approach
Incorporating EM risks
Adjust the required return by adding a
country risk premium
Adjust the cash flows in a scenario analysis (preferred)
Valuation in Emerging Markets
148
Generic DCF model
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• the investor takes a non-control perspective.
DCF
149
Generic DDM
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Dividend Discount Models
150
Gordon growth model Strengths:• Suitable for stable, mature,
dividend paying firms• Easily applied to indices• Easily communicated &
explained• Can be used to determine
growth rates, rates of return and PVGO
• Supplements other methodsLimitations:• Very sensitive to inputs• Not easily applied to non-
dividend paying stocks• Unpredictable growth patterns
makes using the model difficult
Problem with two-stage model with constant growth in both stages
Assumption that a firm’s high growth rate will suddenly drop to a lower level overnight is
highly unrealistic.
Improvement built into H-modelOver a set time the high initial growth will
decline in a linear fashion to the sustainable long-term growth rate
Rationale for three-stage model• With a good product, some companies may
sustain a high growth rate in the short-term
• The business is most likely to go through a growth phase, transitional phase, then mature phase
Spreadsheet approachUsed when even the three-stage DVM is too simple for a real-life application
DCF Commentary
151
Multi-stage modelsStrengths:• Flexibility• Can calculate implied growth rates
or required returns• Can incorporate the impact of
different assumptions into the model• Relatively easy to construct using
spreadsheet softwareLimitations:• Estimates are only as good as the
inputs used• Model must be fully understood to
arrive at accurate estimates• Estimates are very sensitive to
assumptions regarding growth and the required return
• Formula and data input can lead to errors that are difficult to identify
Sustainable growth rate Rate at which earnings (and dividends) can continue to grow indefinitely, assuming that the firm’s leverage is unchanged and no new equity finance is raised.
Estimating return on equity (ROE)
EquityAssetsx
AssetsSalesx
SalesEBIT
EBITEBT
EBTIncome Net
EquityIncome NetROE
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g = b x ROE Where: b = retention rate
ROE = expected return on equity
152
• FCFs are not published but need to be computed from published financial statements
• Free means after fulfilling all obligations and without impacting on the future growth plans of the company
Free Cash Flows to Equity (FCFE)= net income
non-cash items in income statement
- investment in working capital - investment in fixed assets+ net increase in debt
or= CFO*
- investment in fixed assets+ net increase in debt
* Assuming interest received and paid and dividends received have been classified as an operating cash flow as required under US GAAP
Free Cash Flows to the Firm (FCFF)= net income
non-cash items in income statement+ interest expense x (1 – tax rate)- investment in working capital- investment in fixed assets
or= CFO
+ interest expense x (1 – tax rate) - investment in fixed assets
or= FCFE
+ interest expense x (1 - tax rate) – net increase in debt
NB: May be given EBIT or EBITDA as starting point for FCFE or FCFF calculations
FCF Models
153
Calculation of WACC is covered in Corporate Finance
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Forecasting FCF - Apply a growth rate to most recent reported free cash flow or forecast each component separately.Sensitivity Analysis – Often utilized to assess the impact of uncertain assumptions.
FCF Models
154
Preferred to DDM when:• Firm pays no dividends.• Firm is paying dividends but
dividends differ significantly from the firm’s capacity to pay dividends – i.e. dividends imperfectly signal the firm’s long-run profitability.
• Free cash flows appear to be better aligned with profitability over the analyst’s forecast period.
• Investor takes a control perspective since the firm is being analyzed as a takeover target
FCFE v FCFF models For firms with relatively stable leverage, FCFE is more direct and easier to use.Situations where the FCFF approach is more useful include:• proposed purchase of entire firm (i.e. equity
and debt capital) with a subsequent reorganization of the capital structure.
• firms where FCFE is negative.• firms with history of leverage changes –
FCFF may be more meaningful than an ever-changing growth pattern in FCFE.
Free cash flow proxiesBoth net income and EBITDA are regarded as fairly poor proxies since:• both ignore the important distinction between profit and cash flow• both ignore the reinvestment of earnings needed for growth • EBITDA ignores the tax that the firm needs to pay before any distribution to investors
FCF Further Aspects
155
Overview• Price multiples are ratios of a stock’s market price to some measure of value per share.• Method of comparables involves comparing a stock’s price multiple to a benchmark
multiple to determine whether or not the stock is appropriately valued.• Method based on forecasted fundamentals relates multiples to company fundamentals
using a discounted cash flow model.• A justified price multiple is a multiple justified by an analyst based on either of the
above methods.
P/E multiple
• Earnings may not exist or be negative • Need to adjust “book” earnings to
sustainable or recurring earnings• Management discretion with
accounting practices distort earnings and affect comparability of P/Es across companies
• Earnings power is the primary driver of investment value
• P/E ratio is a popular measure with investors
• Empirical research shows that P/Es may be related to differences in long-run average stock returns
Drawbacks of using P/E:Rationales for using P/E:
Price Multiples
156
P/E ratio based on fundamentals
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• Method of historical average EPS – use the average EPS over the most recent full cycle
• Method of average return on equity – use the average ROE (based on the most recent full cycle) multiplied by the current book value per share
Value = earnings x P/E ratio
P/E multiple increases if:• growth rate increases• firm’s risk level decreases causing the
required return to decrease • interest rates decrease causing the
required return to decrease • payout ratio increases (although g will
also be negatively affected)
Determining earnings Analyst may adjust for:• company specific transitory,
nonrecurring components*• transitory components due to
business or industry cyclicality• accounting method differences*• potential dilution (e.g. due to
options and convertibles)
Valuation using P/E
157
Steps for valuation using comparables
1. Select and calculate the price multiple that will be used in the comparison.2. Select the comparison asset or assets.3. Calculate the benchmark value of the multiple, i.e. the mean or median value of the
multiple for the comparison assets.4. Compare the stock’s actual multiple with the benchmark value.5. If possible, assess whether differences in the fundamental determinants of the price
multiple explain any of the difference in 4 and modify conclusions accordingly.
P/E to growth ratio• Step 5 above could involve calculating the P/E-to-g (PEG) ratio.
• A high P/E should be justified by high growth – so this ratio should be roughly constant for all firms in a sector.
• A high ratio may indicate an overpriced share, a low ratio an under priced share.
PEG Ratio
158
Value = book value x P/B ratio
• relies on consistent application of accounting standards
• not good for firms with off Balance Sheet human capital
• depreciated historical cost of assets may be different across similar firms due to the age of the assets
• book value more stable than EPS• works with zero or negative earnings• for some firms, book values of assets
may approximate market values• empirical evidence suggests differences
in P/Bs may be related to differences in long-run average returns
Drawbacks of using P/B:Rationales for using P/B:
Fundamental P/B
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required return to decrease • interest rates decrease causing the
required return to decrease • ROE increases
Book value of equity is:• net assets; or• shareholders’ funds
P/B Ratios
159
Value = sales x P/S ratio
• fails to highlight cost control issues within a firm
• does not reflect differences in cost structures among different companies
• meaningful even if EPS is negative• sales figures less subject to manipulation • less volatile than P/E• viewed as appropriate for valuing the stock of mature,
cyclical and zero-income companies • research suggests that differences in P/Ss may be
related to differences in long-run average returns
Drawbacks of using P/S:Rationales for using P/S:
Fundamental P/S
E/S = profit margin
P/S multiple increases if:• growth rate increases• payout rate increases, but ….• profit margin increases• firm’s risk level decreases causing the
required return to decrease • interest rates decrease causing the
required return to decrease
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P/S Ratios
160
Value = cash flow x P/CF ratio
• certain cash flows are ignored if proxies are used such as EPS plus non-cash charges
• FCFE is superior for valuation but introduces volatility problems and may also be negative at certain times
• addresses the issue of differences in accounting conservatism between companies (quality of earnings)
• cash flows less subject to manipulation than earnings• less volatile than P/E since CF tends to be more
stable than earnings• research suggests that differences in P/CFs may be
related to differences in long-run average returns
Drawbacks of using P/CF:Rationales for using P/CF:
Fundamental P/CF Measures of cash flows that may be used:CFO = cash flow from operationsFCFE = free cash flow to equityCF = earnings plus non cash
charges or incomeEBITDA = earnings before interest, tax,
depreciation and amortization
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P/CF Ratios
161
• focus on D/P is incomplete as it ignores capital appreciation
• dividends now would displace future earnings, which implies a trade-off between current and future cash flows
Drawbacks of D/P approach:
• dividend yield is a component of total return• dividends are not as risky as the capital
appreciation component of total return
Rationales for using dividend yield:
Dividend yield modelValue = annualized dividend / dividend yield
Enterprise Value/EBITDA• EV = MV of all equity and debt less cash
& liquid investments = NPV of firm’s earning activities
• EV should be a predictable multiple of EBITDA
Rationales for using EV/EBITDA:• Useful in comparing firms with different
financial leverage• Eliminates accounting manipulation in
depreciation & amortization• EBITDA more stable than other earnings
measures, and normally positiveDrawback of using EV/EBITDA:
• EBITDA ignores required capital and working capital investments
price Marketquarters four next over dividends ForecastedD/P Leading
price Market4dividendquaterly recent MostD/P Trailing
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Other Models
162
Overview• Residual Income = accounting profit - charge for equity capital employed
• Residual income represents returns in excess of shareholder expectations, or “economic income”
Forecasting residual income• This might use internal management
forecasts for the next few years. Problem = bias.
• Could use fundamental forecasts of earnings growth and dividend policy.
The general model
where:V0 = value of share todayB0 = current per-share BV of equityBt = expected per-share BV at time tr = required rate of return on equityEt = expected EPS for period tRIt = expected per-share RI
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recognition of value is different in the RI model.
• The total PV produced by all models should be consistent, in theory, so long as each uses fully consistent assumptions.
Residual Income Models
163
Drivers of RI and link to P/BAssuming a constant growth rate in earnings, g, and a constant ROE and dividend payout, the residual income valuation model simplifies to:
This formula is linked to:
Multi-stage RI model – Continuing RI • Continuing residual income is residual income
after the forecast horizon.
• It is likely that residual income will decline in the long run until the firm is making a “normal” return (i.e. ROE = r � RI = 0).
• Possible continuing RI assumptions are:• RI continues indefinitely at a positive level• RI is 0 from the terminal year forward• RI declines to 0 as ROE reverts to r over time• RI reflects reversion of ROE to some mean
Applicable RI model when RI fades over time from time T
w (fade rate) takes values between 0 and 1:
w = 0 � no expectation of any future RI
w = 1 � same level of RI continuing forever
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Residual Income Models
164
Implied Growth RateCan be calculated given the P/B ratio and the required rate of return on equity by rearranging the single-stage RI formula:
Justifying Continuing RI PersistenceFactors suggesting high :
• Low dividend payout ratios
• High historical industry persistence
Factors suggesting low :
• Very high rates of return (ROE)
• Large special items e.g. non-recurring items
• Large accounting accruals
Problems Applying RI Models• violations of clean surplus: currency translation adjustments, minimum liability adjustment,
unrealised gains/losses on available-for-sale securities
• off-balance sheet items: operating leases, LIFO inventory, goodwill, assets/liabilities not at FMV
• non-recurring items: extraordinary items, discontinued operations, accounting changes
• Differing international standards
RI Models – Further Aspects
165
• Easily manipulated by changing accounting assumptions
• Ignore changes in reserves other than income and dividends
• Many adjustments may need to be made to accounting data to get comparable figures
• Terminal value doesn’t dominate estimate
• Uses available accounting data• Useful even if firm doesn’t pay dividend,
and not distorted by irregular dividends• Can be used with unpredictable cash
flows• Models focus on economic profitability,
not just accounting profitability
Weaknesses of RI models:Strengths of RI models:
When to use a RI model:RI model is most appropriate when:
• company does not pay dividends, or its dividend are not predictable• company’s expected FCFs are negative within the analyst’s forecast horizon• great uncertainty exists in forecasting TVs using an alternative PV approach
RI model is least appropriate when:
• there are significant departures from “clean surplus accounting”• determinants of RI are not predictable
RI Models Commentary
166
Alternative measuresRI (see earlier slide)
EVA® = NOPAT – (WACC x IC)
MVA = Market value of firm – IC
Accounting vs Economic ProfitabilityEconomic profitability reflects the dollar cost of debt and equity capital used to generate cash flow.
Accounting profitability (ROE) only includes an accounting accrual related to interest expense.
One way of assessing relative economic profitability is to compute an EVA spread:
EVA spread = ROC – WACC
where ROC = NOPAT/Invested Capital
Methods of Increasing EVA®• Increase Revenues• Reduce operating expenses• Use less Invested Capital• Take advantage of positive NPV
projects• Reduce WACC
Value-Based Metrics
167Private Company Valuation
Private Company Specific Factors• Stage of lifecycle, size, Taxes• Quality and Depth of Management• Management/Shareholder overlap• Quality of financial and information• Liquidity, Marketability, Control
Private Company Valuation Approaches• Income Approach �PV of expected future income � High Growth Phase Companies• Market Approach � Recent Transaction Price Multiples � Mature Phase Companies• Asset-based Approach � Firm’s assets’ value minus liabilities � Early Stage Companies
Liquidity and Marketability• Minority referred to Liquidity• Difficult to be sold referred to Marketability� DLOC = 1-[1/(1+control Premium)]� Total discount = 1-[(1-DLOC)(1-DLOM)]
Scenario Comparable Data Subject Valuation Adj. to Comp. data for control
1 Controlling Interests Controlling Interests None
2 Controlling Interests Noncontrolling Interests DLOC
3 Noncontrolling Interests Controlling Interests Control Premium
4 Noncontrolling Interests Noncontrolling Interests None
168
Alternative InvestmentsStudy Sessions 13
Weighting 5 – 15%
169SS13 Overview
Alternative AssetValuation
Private EquityInvestment Analysis Income Property Hedge Funds
170Real Estate Investments
Type Main Value Determinants
InvestmentCharacteristics
Principal Risks Likely Investor
Raw Land Supply/demandLocation
Passive, illiquid, limited leverage, no tax depreciation, CGT, low current income
Alligator! Uncertain appreciation
Speculators, developers, long-term investors
Apartments No of households, incomes, location, population growth
Active management, both current income and capital gains, high liquidity and leverage, inflation hedge
Startup risks due to uncertain demand, need of professional management
Well capitalised in need of tax shelter
Office buildings
Business conditions, location, tenant mix
Active management, income and capital gain, moderate liquidity and leverage
Startup risk, obsolescence, quality of management , competing properties
High net worth companies and individuals in need of tax shelter
171Real Estate Investments cont.Type Main Value
DeterminantsInvestmentCharacteristics
Principal Risks Likely Investor
Warehouses Commercial and industrial activity, flexibility of design, easy access and convenience
Passive, moderate liquidity and leverage, mostly income
Oversupply (cheap) and obsolescence
Investors seeking high cash flow, minimal management and tax shelter
Shopping centres
Population, income level, location, tenant mix, lease terms
Active management, low liquidity, moderate leverage, both income and capital gain, tax advantages
The right tenant mix, obsolescence, competition, maintaining quality management, high vacancy rates
Well capitalised seeking tax shelter
Hotels and Motels
Level of business and tourist activity, location
Active management, limited liquidity, and leverage, tax depreciation
Economies of scale, quality management, competing facilities
Wealthy investors or REITS
172
Valuing Real EstateGenerally use NPV or IRR analysis
CFAT = cash flow after taxesERAT = equity revision after taxEI = initial equity investment
Steps in Calculating CFATStep 1: Compute taxes payable
Taxes payable = (NOI – depreciation –interest) tax rate
Step 2: Compute cash flows after tax (CFAT)CFAT = NOI – debt service – taxes payable
Step 3: Compute equity reversion after taxesERAT = selling price – selling costs –mortgage balance – taxes on sale
IRR Problems• Multiple or no IRR are the result of cash flow changing
signs more than once - common with property renovations
• Misleading IRR decisions due to size and timing of cash flows
• Conflicting IRR and NPV decisions for mutually exclusive projects
• Solution - use the NPV methodology and select projects with positive NPV
Evaluating Real Estate• If NPV > 0, or NPV = 0, then
purchase the property. A positive NPV means that the present worth of the property is greater than the equity cost of the investment. A zero NPV means the investors equity cost is unaffected
• If NPV < 0, don’t invest in the property as it destroys value
Valuing Real Estate
EIIRR
ERATIRR
CFATIRR
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173
Cap Rate and Discount Rate•Discount rate (r) - the required rate of return on a real estate investment given the risk and uncertainty of cash flows
•Cap rate (r – g) - the required return less the expected growth of net operating income (NOI)
Methods to Estimate Cap RateMarket Extraction Method – considered the most accurate but depends on appraisal data and comparable properties
Band-of-Investment Method – useful for properties that utilise both debt and equity financing; uses a sinking fund factor to calculate the cap rate as a WACC figure; depends on comparable property data
Built-up Method - Useful when comparables not available
Property Analysis and Appraisal
1 10
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Limitations of Direct Income Capitalisation•Selecting the correct cap rate may be difficult due to lack of available market data, or low-quality data•Approach is limited to income-generating properties, not owner-occupied properties with non-monetary benefits•Properties that provide little or no income or benefits cannot use this method
174
Value CreationReengineer firm
Obtain lower cost financing
Goal alignment
Exit RoutesIPO
Secondary Market
MBO
Liquidation
VC v Buyout Characteristics�Cash flow�Product �Asset base�Management team entrepreneurial record�Leverage�Risk assessment �Exit strategy�Operations�Capital required in growth phase�Returns�Activity in public capital markets�Future funding �Carried interest
Private EquityRisks
LiquidityCompetitionAgencyCapitalRegulatoryTaxValuationDiversificationMarket
Structure and TermsStructure – LPTermsManagement fees
Carried interest
Ratchet
Hurdle Rate
Target fund size
Vintage
ValuationDue Diligence
CostsTransaction Placement feeFund set up Performance feeAdministrative Management feeAudit
175Private EquityControl Mechanisms in PE
TransactionsCompensation & Tag-along, drag-along clauses
Board representation & Non-compete clauses
Priority in claims, Required approvals, & Earn-outs
Corporate Governance terms Key man clause & performance disclosure and confidentiality
Claw-back & distribution waterfall
Tag-along, drag-along clause & Remove for cause
No-fault divorce & Investment restrictions
Co-investment
Valuation Methodologies DCF
Relative value or Market approach
Real option analysis
Replacement cost
VC method & leverage buyout method
Calculating Payoff Multiples and IRRsCalculating the exit value
Calculating the claimant’s payoffs: Debt, Preference shares, PE firms, Management
Calculating the total investment and total payoff, using these two can get the Payoff Multiples for PE firms
Calculating the IRRs for PE investors and management equity
176Private EquityPerformance Measurement
�Multiples: Popular, simple, easy to use and differentiates between realized and unrealized returns, specified by GIPS�Paid in Capital (PIC) – % of capital used by GP
�Distributed to PIC (DPI) – measures GP realized return, cash on cash return
�Residual Value to PIC (RVPI) –measures LP’s unrealized return
�Total value to PIC – measures LP’s realized and unrealized return, sum of DPI, and RVPI
ValuationIssue
Buyout VentureCapital
Use of DCF
Frequently used
Uncertain cash flow
RelativeValue
Validates DCF
No comps
Use of Debt
High Low, more equity
Keyreturndrivers
EPS growth, P/E expansion, debt reduction
Pre-money valuation, future dilution
Other ValuationVC – Single / Multiple financing rounds
LBO - Target IRR
- Cash flow
177Private EquityFor a Single Financing Round
Step 1: Post-Money Valuation
POST = FV /(1+r)N
Step 2: Pre-Money Valuation
PRE = POST-INV
Step 3: Ownership Fraction
f = INV/POST
Step 4: No. of the shares to be held by the PE firm
Spe = Se [f/(1-f)]
Step 5: Price per share
P = INV/ Spe
For Multiple Financing RoundsStep 1: the compound discount rateStep 2: Post-Money Valuation (round 2)POST2 = FV/ (1+ r2)Step 3: Pre-Money Valuation (round 2)PRE2 = POST2 – INV2Step 4: Post-Money Valuation (round 1)POST1 = PRE2 / (1+ r1)Step 5: Pre-Money Valuation (round 1)PRE1 = POST1 – INV1Step 6: Ownership Fraction (round 2)f2 = INV2 / POST2Step 7: Ownership Fraction (round 1)f1 = INV1 / POST1Step 8: No. of the shares to be held by the PE firm Spe1 = Se [f1 /(1- f1)]Step 9: Price per share after financing (round 1)
P1 = INV1 / Spe1Step 10&11: Price per share after financing (round 2)
Spe2 = (Se + Spe1) [f2 /(1- f2)]P2 = INV2 / Spe2
178Private EquityIRR Method
Ownership Fraction
Step 1: Investor’s expected future wealth W = INV (1+r)N
Step 2: Ownership Fraction f = W/FV
Price per share
Step 3: No. of the shares to be held by the PE firm Spe = Se [f/(1-f)]Step 4: Price per share P = INV/ SpePost-Money & Pre-Money Valuation
Step 5: Post-Money valuationPOST = INV/f or POST = P
(Spe+ Se)Step 6: Pre-Money valuation
PRE = POST - INV or PRE = P Se
Adjusting the Discount Rater* = [(1+r)/(1-q)] – 1r* = discount rate adjusted for probability of failurer = discount rate unadjusted for probability of failureq = probability of failure in a year
Target IRR MethodTarget IRR must meet or exceed:The cost of the LBO debt financingThe cost of equity capital for a similar unlevered firmThe return that the fund managers market to client investors
Equity Cash Flow MethodDiscount the future value of equity back to the present using an expected return on equity for each period that reflects the then capital structureThe beta for equity that accounts for the financial leverage:
N
terminalequity valuePV of equity investment =(1+target IRR)
AssetEquity E
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179
179
Fee Structures•Paid on quarterly or annual basis•High-water mark provision
Hedge Fund Returns•Factor models•Alpha: manager skill•Beta: market exposure•Hedge fund returns are often not normally distributed Sharpe ratio or other classical ratios may be useless
Hedge FundsPerformance biases
•Voluntary report to databases•Selection bias•Backfill bias•Survivor bias
Funds of funds (FOF)•Retailing (exposure to a large number of hedge funds)•Access to funds closed to individuals•Diversification•Expertise•Due Diligence Process
Hedge Fund Strategies•Arbitrage-based funds•Convertible bond arbitrage strategies•Equity market neutral funds•Event driven funds•Risk arbitrage (merger arbitrage)•Fixed-income arbitrage•Medium volatility arbitrage•Global macro funds•Long-short equity funds•Managed futures funds•Multi-strategy funds•Directional hedge fund strategies•Dedicated short bias funds•Emerging market hedge funds
180
180
Market risks •Can be limited by understanding the beta exposures of individual hedge funds and increase the allocation to funds with lower market risks•Alternatively, allocate to managers with the highest alpha and hedge away the common factors at the FOF level
Hedge Fund Risk
Event risks•Event driven funds, such as those following mergers and distressed or special situation investments•Event driven funds have a lower correlation with market indices, but their returns can change dramatically with event risk•Events may affect broader market risks
Operational risks•Include inadequate resources, unauthorized trading and style drift, the theft of investor assets, and misrepresentation of investments and performance•Can be minimized by a strict delineation of duties
Counterparty risk•Arises when owed money on a swaps or options contract and the seller of the contract fails to deliver the gains
Leverage•Can magnify market risk and counterparty risk•Can be gained through derivatives
181
Fixed Income InvestmentsStudy Sessions 14 & 15
Weighting 5 – 15%
182Overview of Level II Fixed Income
General Principles of Credit Analysis
Term Structure and Volatility of
Interest Rates
Valuing Bonds with Embedded Options
Study Session 14: Valuation Issues
Mortgage-backed Sector of the Bond Market
Asset-backed Sector of the Bond Market
Valuing MBS/ABS
Study Session 15: Structured Securities
183Credit Analysis
Key ratios• Profitability• Short-term solvency• Capitalization/Leverage• Coverage
Credit Risk� Default Risk� Credit Spread Risk� Downgrade Risk
� High yield issuer – Debt structure (bank loans), corporate structure, covenants
� Asset Backed Securities - Quality of underlying collateral
� Municipal Securities – Tax/revenue-generating ability of the issuer
� Sovereign Debt - Economic and political risk – 2 ratings (local & foreign currency debt)
Key Considerations
The 4 Cs• Character• Capacity• Collateral• Covenants
184Credit Analysis S&P Framework
Net income+ Depreciation+/ Other noncash items
Funds from operationsIncrease in NWC
Operating cash flowCapital expendituresFree operating cash flow
– Cash dividendsDiscretionary cash flow
–Acquisitions+Asset disposals+Other sources (uses)
Prefinancing cash flow
Cash flow ratios
Coverage ratios
Funds from operationsTotal debt
Funds from operationsCapex
Free operating CF + interestInterest
Debt service coverage
Free operating CF + interestAnnual interest + principal
Debt payback period
Total debtDiscretionary CF
185Term Structure
Parallel shifts
Yield Curve Shifts
Twists
Butterfly shifts
Yield curve construction: 4 bond universes
• on-the-run Treasuries• on-the-run + some off-the-run Treasuries• all Treasuries• Treasury stripsAlternative: swap rate (LIBOR) curve
Shape of yield curve� Defined by “term structure” of interest
rates� Three theories:
- pure expectations (shape shows expected implied forward rates)- liquidity theory (long-term bonds give higher yield to compensate for higher IR risk)- preferred habitat (investors must be compensated for investing in less-preferred habitat)
Yield
Maturity
Yield
Maturity
New steepened curve
Original curve
Yield
Maturity
Positive butterfly shift
Original curve
Yield
Maturity
Original curve
Megative butterfly shift
186Volatility of Interest Rates
Impact of non-parallel shifts on price measured by Key
Rate Duration
Approximate percentage change in value in response to a 100 basis point change in a
key rate, holding all other rates constant
Historical yield volatility
Implied volatility
Yield volatility and
measurement
Forecasting yield volatility
Volatility derived from option pricing
models
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Maturity
Spot rate
key rate
Effective Portfolio Duration = Sum of Key Rate Duration
187Bonds with Embedded OptionsBinomial Model
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Callable: call price is effective cap at each node
Putable: put price is effective floor at each node
Backward induction1. Populate interest rate
tree with rates2. Discount from end3. At each node take
average price, consider call/put and add cash flow
Spread measures� Nominal spread
= YTMcorp – YTMTreas(ignores shape of yield curve)
� Zero-volatility/Z/Static spread- spread added to spot rates to get theoretical bond price = actual bond price
� Option-Adjusted Spread- spread added to the interest rate tree to get theoretical bond price = actual bond price
Treasury term structure
z-spread: credit, liquidity and option risks
OAS: credit and liquidity risks only
“option cost”
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188Relative Value Analysis
OvervaluedOvervaluedOvervaluedActual
OAS < 0
Fairly pricedOvervaluedOvervaluedActual
OAS = 0
UndervaluedUndervalued if actual OAS > required OAS*
Undervalued if actual OAS > required OAS*
ActualOAS > 0
IssuerBenchmarkSector BenchmarkTreasury
Benchmark
*Relative to same benchmark
189Convertible Bonds
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Convertible bond value = Straight value + equity call option – bond call option + bond put option
“Common stock equivalent” (conversion value > straight value) vs..“Fixed income equivalent” (conversion value < straight value)
190Mortgage-Backed Securities
US Mortgage market – key features
Home loans in the form of fixed-rate level-payment fully amortized mortgages
Mortgage Passthrough SecuritiesOnly one class of bond investorCash flows: net interest, principal payments, curtailmentsMostly issued by agencies: Ginnie Mae, Fannie Mae, Freddie Mac
principal outstanding
t
Non-agency MBS� Collateral can be individual loans (vs.. passthrough securities for
agency MBS)� No government guarantee� Normally have max LTV, payment-to-income and size criteria
Pool
Mortgage 1
Mortgage 2
Mortgage N
…
Investor 1
Investor 2
Investor N
…
Pass-through securities backed by the pool are issued to investors
191Mortgage-Backed Securities
Prepayment RatesPSA Benchmark
Assumes the monthly prepayment rate increases as it seasonsCPR
Conditional prepayment rate (CPR) is the expected annual prepayment rate.
Can be converted to SMM (single-monthly mortality rate):
� � 12/1CPR11SMM ���
Contraction Risk: IR # hence prepayments $ hence expected life #
Extension Risk: IR $ hence prepayments # hence expected life $
Factors affecting prepayment behaviour1.Prevailing mortgage rates2.Housing turnover3.Characteristics of the underlying mortgage loans
Annual CPR
Age in months
30
100 PSA
50 PSA
125 PSA6%
3%
7.5%
192Mortgage-Backed Securities
Mortgage Paythrough SecuritiesSeveral classes of investors
Collateralized Mortgage ObligationsSecurities issued against passthrough securities for which the cash flows have been reallocated to different bond classes known as tranches
Planned Amortization Class
TranchesAmortized based on a sinking fund schedule established within a range of prepayment speedsSupport tranche absorbs any excess
Stripped MBSPrincipal and interest payments are paid to different security holders:
Interest Only (IO) StripsPositively related to mortgage rates: as IR #there is more prepayment of principal leading to less cash flow for the IO strip
Principal Only (PO) Strips
Very sensitive to prepayment ratesPrices rise as IR #
Sequential Pay Tranches
Each class of bond retired sequentiallyTranche A – Most Contraction RiskTranche Z – Most Extension Risk
193Commercial MBS
• CMBS are backed by a pool of commercial mortgage loans on income producing property
• CMBS differ from residential MBS in that they are non-recourse loans. Hence each property must be assessed in isolation rather than as a pool
• Call Protection at the Loan Level– Prepayment lockout– Defeasance– Prepayment penalty points– Yield maintenance charge
• Call Protection from the actual CMBS structure: as the CMBS is sequential paying (by credit rating), the AA rated tranche cannot be repaid before the AAA rated tranche• Debt-to-service coverage (DSC) ratio
= ratio of net operating income to debt service.
• Need DSC need > 1, but also check average & dispersion.
• Loan to Value (LTV) ratio• The lower the LTV, the greater the
protection afforded to the lender• Note value estimates may vary
considerably
Balloon RiskRisk of default at end of loan, when most of repayment is due
194Asset-Backed SecuritiesABS: Key Features
Credit Enhancements
Types� credit card receivables� auto loans� home equity loans� manufactured housing loans� Small Business Admin loans� corporate loans� bonds� other credit-sensitive receivables
Amortizing (e.g. auto loans) vs..
Non-amortizing (e.g. credit card loans)
vs.
Prepayment (sequential pay ABS, tranches having differing prepayment/extension risks)
vs.Senior-subordinate structure
(senior tranche protected against default by subordinate) a.k.a.
credit tranching
Internal credit enhancements:1. Reserve funds2. Overcollateralization3. Senior/subordinated structure
External credit enhancements:1. Corporate guarantee by seller2. Bank letter of credit3. Bond insurance
195Types of Asset-Backed Security
Credit Card Receivables• Non-amortizing, with cash
flows = interest, fees, principal
• 3 amortization structures: passthrough, controlled amortization, bullet payment
• Prepayment measured by “monthly payment rate”
Home equity loans• Often closed-ended HELs,
fixed or floating rate
• Cash flows similar to MBS
• Can be split into tranches: NAS vs. PAC
• Prepayments are modelled on issuer-specific prospectus prepayment curve (PPC)
Manufactured housing loans
• Amortizing over 15-20 yrs
• Lower prepayments than MBS because (1) small loans, (2) depreciating collateral, (3) low credit quality of borrowers
• Prepayment model: CPR with PPC
Student loans• Floating rate, with
deferment, grace & repayment periods
• Prepayments from defaults or loan consolidations
SBA loans• Variable rate, 5-25
years
• Prepayments measured via CPR
Auto Loans• Prepaid if sold, traded in, repossessed,
destroyed (insurance proceeds), early repayment or refinanced – but…
• Refinancing uncommon since collateral value depreciates rapidly and new car loans often below market rates
• Prepayments: CPR & SMM
196ABSs: Other issues
Collateralized Debt Obligations
CDO = ABS backed by pool of bonds, loans, MBSs or ABSs
Arbitragetransaction
(motivation: earn the spread)
vs.Balance sheet
transaction (motivation:
remove debt from B/S)
Cash CDO (underlying =
cash debt instruments)
vs.Synthetic CDO
(credit derivatives
create economic equivalence to
cash instruments)
197Valuing MBS/ABSTechniques for valuing MBSs and ABSs
Cash flow yield analysisDiscount rate that makes the present value of the future cash flows equal to the current price. Prepayment assumption required.
Can calculate bond equiv yield:
]1)i1[(x2BEY 6M � �
Spread measures� Nominal spread: hides
prepayment risk� Z-spread: same
problem, but considers y.c. shape
� OAS: best measure
Monte Carlo and spreadsThe rates in the Monte Carlo model can be “tweaked”so that model’s resultant price of MBS/ABS = market price.
Level of “tweak” is the OAS, since the model incorporates the prepayment option.
Hence for investing: biggest OAS = cheapest investment
Best spread measure for valuations
� no option (or option exercise unlikely): use Z-spread
� embedded option, not IR path dependent: OAS with binomial
� embedded option, IR path dependent: OAS with Monte Carlo
Monte Carlo vs. binomialMonte Carlo incorporates IR path, so can use prepayment model to produce value.
Binomial model does not have ability to value securities that are IR path dependent, since backward induction starts at end of timescale.
198Duration Measures MBS/ABS
MBS Duration Measures
Effective DurationFrom Monte Carlo model. Shock yield by +/-�y, reapply the model then plug results into duration formula.
Cash Flow DurationEstimate CF and hence CF yield, shock yield by +/-�y, re-estimate CFs and hence new prices, then plug results into duration formula.
Coupon Curve Duration
Calculate duration by changing couponinstead of yield.
Empirical DurationUse linear regression to identify how price changes with yields.
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199
Derivative InvestmentsStudy Sessions 16 & 17
Weighting 5 -15%
200Overview of Level II Derivatives
Forward Market and Contracts
Future Market and Contracts
Study Session 16: Derivatives Investments: Forwards and Futures
Options Market and Contracts Interest Rate
Derivatives Instruments
Credit Derivatives
Study Session 17: Derivatives Investments: Options, Swap and Interest Rate
Swap Market and Contracts
201Forward Contracts
Obligation to:� buy (long)� sell (short) an asset at an agreed price on an agreed forward date
Value & Price– Value = PV of net advantage to long from
having contract at forward price (FP)– Price = FP set when contract initiated, for
no-arbitrage must = cash asset price + net cost of carry
Credit riskParty with the positive value faces credit risk in that amount
202Forward Contract Prices & Values
PV of difference between interest at FRA rate and at the current forward rate for the FRA period
Calculate the forward interest rate. E.g. 4 7 FRA, use fwd rate from time 4 to 7
FRA
Currency Forwards
Equity Index Forwards
(So - PVD) x (1+Rf )TEquityForwards
VALUE (to the long at time t)= (spot price – PV benefits)– PV of forward price
FORWARD PRICE= spot price + net costs of carry
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203Futures Contracts
Like forwards, but standardised, exchange traded and subject to margining
Basis = spot price – futures priceContango = negative basis. Most likely scenario.Backwardation = positive basis. It will occur if benefits holding assets large enoughConvergence As maturity approaches, basis converges to zero (due to arbitrage)
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Futures price v. Forward price
– In principle same no-arbitrage price applies to both
– But investors preference for mark-to-market feature (cash flow effect) could make futures more (/less) valuable than forwards
– Effect of mark-to-market ignored on following slides
204Futures pricingFutures arbitrage– Futures price (like forward) determined by arbitrageIf futures trades above theoretical FP then: Cash and carry arbitrage– Buy cash asset with borrowed money and sell futureIf futures trades below theoretical FP then:Reverse cash and carry arbitrage– Short sell cash asset, invest proceeds, and buy future
Generic futures pricing formula:
FP = S0 (1 + Rf)T +FV(NC)-FVD
NC=Storage Cost-Convenience Yield
FVD=Future Value of Cash Flow
Convenience Yield: Non-monetary benefits from holding asset, e.g., holding asset in short supply with seasonal/highly risky production process
Eurodollar deposits vs T-bills•Eurodollar deposits are US$ denominated deposits outside the US priced off the LIBOR curve using 360 day convention•While T-bills are discount instruments, Eurodollar deposits are add-on instruments
Difficulty in pricing Eurodollar futures•Eurodollar futures cannot be priced easily as LIBOR is an add-on interest and arbitrage transaction cannot be constructed perfectly as is the case with T-bill futures
205Pricing Financial Futures
FP = [(So x (1+Rf )T) – FV(Coupons)]/CFS0,CF = Price, Conversion Factor of CTD bond (Cheapest To Deliver bond gives highest implied repo rate)
T-Bond
Exactly the same as for forwardsEquity & Currency
PriceType of Future
Normal Backwardation• Hedgers (shorts) are rejecting
price risk• Speculators (longs) will require
compensation to accept risk•Result: Futures price < expected spot price
Normal Contango• Hedgers (longs) are rejecting
price risk• Speculators (shorts) will require
compensation to accept risk•Result: Futures price >expected spot price
206Options basics (refresher)
call payoff = max(0, ST – X)call profit = max(0, ST – X) – C0
put payoff = max(0, X – ST)put profit = max(0, X – ST) – P0
Long LongShort Short
Call Put
B/E = strike + prem
B/E = strike -prem
Max loss = premium
Max profit = premium
Max profit = unlimited
Max loss = unlimited
Max loss = B/E
Max profit = B/E
207Options Jargon (refresher)
Call PutIn the money S – X = +ve; S – X = –veOut of the money S – X = –ve; S – X = +veAt the money S – X = 0; S – X = 0
– Moneyness– Strike/exercise price (X)– Underlying price (S)– expiration– European/American– Intrinsic value– Time value
Intrinsic value– Call: Max (S-X,0)– Put: Max (X-S,0)
Time value– Premium minus Intrinsic value
208Caps, floors, collars
Collar– (long) collar = long cap + short floor– zero cost if cap premium = floor premium
Cap– series of interest rate caplets,
calls with identical strikes & equally-spaced expiries
– bought by borrower
Floor– series of interest rate floorlets, puts
with identical strikes & equally-spaced expiries
– bought by lender
209Put-call parity
Synthetics– c0 = p0 + S0 - X/(1+r)T (synthetic call = long put + long underlying + short bond)– p0 = c0 - S0 + X/(1+r)T (synthetic put = long call + short underlying + long bond)– S0 = c0 - p0 + X/(1+r)T (synthetic underlying = long call + short put + long bond)– X/(1+r)T = p0 - c0 + S0 (synthetic bond = long put + short call + long underlying)
Arbitrage – If Put-call parity doesn’t hold then any of the equations below tells you how to get a profite.g. if c0 > p0 + S0 - X/(1+r)T then sell call and buy synthetic call (buy put & U/L & sell bond [=borrow])
for options on futures:c0 + [X - f0(T)]/(1+r)T = p0
Cost of fiduciary call (long call + Zero Coupon Bond): c0 + X/(1+r)T
must equal cost of protective put (long put + stock): p0 + S0
210Option pricing models
Discrete time – underlying asset is assumed to move only at discrete points in time
Continuous time – underlying asset can move at any point in time
e.g. Binomiale.g. Black-Scholes-Merton
limit of discrete time model as period length 0
211Binomial option pricing
SymbolsS = stock price at start of periodS+ = upper potential end-of-period stock price = S uS- = lower potential end-of-period stock price = S d
(if d is not given, then assume d = 1/u)c+ = call value at expiry if stock rises = Max(0,S+ - X)c- = call value at expiry if stock falls = Max(0,S- - X)r = risk-free rate per period
Hedge ratio (delta) – a risk-free portfolio requires n units of stock per call, where n (hedge ratio) =
�
�
��
SScc
Option value – for no arbitrage, call price at start of a period:
where:r1�)c(1�cc
�
��
dudr1�
��
�
Valuing American optionsAt each point, substitute intrinsic value if larger than ‘roll-back’ value
Given call value can estimate put from put-call parity
2122-period Binomial example (1)
� Stock price = $100� Each period stock either rises 25% or falls 20% (so u = 1.25, d = 0.8)� European call option expires at end of two periods, strike = $97.5� Risk free rate = 7% per period
Stock = $100Call = ?
Stock = $125
Stock = $80
either
or
Stock = $156.25Call = $58.75
Stock = $100Call = $2.50
either
or
Stock = $64Call = $0
either
or
AB
C
2132-period Binomial example (2)
� At all three points (because r, u, and d are the same each period): 6.0
8.025.18.007.01
dudr1� �
��
���
�
� Point B (i.e. at end of first period, assuming stock price rose):
! ! $33.881.07
$2.5)6.0(175.58$0.6r1
�)c(1�cc B ��� �
�
� �
�
� Point C (i.e. at end of first period, assuming stock price fell):
! ! $1.401.07
$0)6.0(15.2$0.6r1
�)c(1�ccC ��� �
�
� �
�
� Point A (now, using cB as c+ and cC as c-):
! ! $19.52��� �
�
� �
1.07$1.40)6.0(188.33$60.
r1�)c(1�cc CB
A
214Valuing interest rate options
Valuing an option on a bond- work backwards to value the
bond at each point in the tree- value option on bond using
conventional binomial approach
Valuing a cap or a floor- use rates in tree to evaluate
payoff for each caplet/floorlet- use rates in tree to discount p-
weighted payoffs back to a PV
interest rates in tree will be provided, and assume p = 0.5
Binomial Model
� ��� 2L,1U,1 eii
215Black-Scholes-Merton model
Assumptions of BSM– Underlying asset price follows a geometric lognormal diffusion process– Risk-free rate and volatility of asset known and constant over option life– No cash flows (e.g. dividends) on the underlying– No transaction costs or taxes– European style options
)N(dXe)N(dSc 2Tr
10
c���
� � � �� �T�
T/2�rlnd2c
XS
1
0 �
T�dd 12 ��As per binomial, given call value can estimate put from put-call parity
216Extensions of BSM
)N(dXe)N(deSc 2Tr
1�T
0c�� ��
BSM Model with dividends
� �� � � �� �T�
T/2�rlnd2c
XeS
1
T -�0
�
!)XN(d)(T)N(dfec 210Tr c
�� �
Black’s model (options on futures)
� � � �T�
T/2�lnd2
X(T)f
1
0 �
Application to interest rate options –replace f0(T) with forward interest rate from the date of expiration of option to end of period of underlying interest rate in the option
T�dd 12 ��
217The Greeks
PositivePositiveVegaVolatility
Interest rate
Passage of time
Underlying price
Factor
NegativePositiveRho
NegativeNegativeTheta
NegativePositiveDelta
Relationship between change in factor and change in premium
PutCall
Factor sensitivity
priceasset ueoption val
��
expiry to timeueoption val
��
rateinterest �ueoption val �
y volatilitprice ueoption val
��
priceasset Delta
��
�GammaEstimating volatility:� Historical (std. devn. of past log returns)� Implied (by pricing model & current premium)
218Delta hedging
0
2
4
6
8
10
12
14
16
12 14 16 18 20 22 24 26 28 30 32 34 36
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1Intrins ic value Total value delta (right ax is)
Delta is the slope of the premium versus asset price line. Call deltas vary between 0 and +1 (since the line moves from being flat to a 450 slope)
Gamma is the slope of this line, it measures how fast delta changes as the underlying price moves. It is positive, and greatest for ATM options
� A long position in a stock with a short position in call options so value of portfolio does not change with the value of the stock.
� Number of calls required =(but beware of gamma)delta call
shares ofnumber
219Swaps and swaptions Plain Vanilla Interest Rate Swap• An agreement to exchange fixed rate
payments for floating rate payments• Based on a notional principal. • Payments are netted off• Equivalent to issuing a fixed-coupon bond
and using proceeds to buy a floating-rate bond
• Equivalent to a series of off-market FRAs• Equivalent to a series of interest rate calls
and puts
Currency Swap• An agreement to exchange payments
denominated in one currency with payments in another currency.
• Principal amounts are exchanged at the start and end of the swap.
• Interest payments not netted off as they are in different currencies
• Equivalent to issuing a fixed- or floating-rate bond in currency A, converting proceeds to currency B and buying a fixed-or floating-rate bond in the latter currency
Equity Swap• An agreement to swap fixed
payments for a return on a stock or stock index
• If the equity returns are negative, the fixed rate payer must also pay the percentage decline
• Equivalent to buying/selling equity A and selling/buying the bond/equity B
SwaptionsPayer Swaption� An option to enter into a pay fixed swap� As interest rates increase, the option
becomes more valuableReceiver Swaption� An option to enter into a receive fixed swap. � As interest rates decrease, the option
becomes more valuable
220Pricing and valuing swaps
Pricing (setting the fixed rate)
Interest rate swap pricing� Use the premise that an interest
rate swap is equivalent to issuing a fixed rate bond and investing in a floating rate bond.
� The fixed rate must be set so that the values of the 2 bonds are the same at initiation.
� At issue, the floating rate bond has a value equal to its face value.
� Therefore, the value of the fixed rate must be: � �
� ��
flow ifor DFflowlast for DF-1F th
Valuation- Difference between PVs of the two
flows- Discount fixed cash flows at the new
LIBOR rates- use fact that PV of FRN at coupon
date = par to simplify floating rate PV- NB LIBOR at the start of each
coupon period determines the coupon paid at the end of the period
221Swaption
Value of Payoff for a Payer Swaption)� PV of the difference between
payments based on higher existing (market) swap rate and payments based on strike rate
� Discount CFs based on “spread”between contract and market
Payer swaption� Right to enter swap as fixed-
rate payer (wins if rates increase)
Receiver swaption� Right to enter swap as fixed-
rate receiver (wins if rates fall)
Uses� Hedge anticipated floating rate
exposure in the future
� Speculate on IR changes
� Terminate an existing swap (i.e., buy the right to enter into an offsetting position)
222Interest rate options
� Interest rate call payoff:Notional principal
Max(0,underlying rate at expiry – exercise rate) (days in underlying rate/360)� Interest rate put payoff:
Notional principal Max(0,exercise rate - underlying rate at expiry) (days in underlying rate/360)
� For both types:• payoff is at end of underlying notional loan period, rather than at expiry (for other
options payoff is at expiry)• compare with FRAs• Cap = series of interest rate calls• Floor = series of interest rate puts
223Credit Default Swap
Strategies� Basis trade� Credit curve flattener� Credit curve steepener� Index trade� Options trade� Capital structure trade� Correlation trade
Characteristics� Insurance contract on
“reference obligation” (a specific bond or loan)
� Buyer pays seller default swap premium (default swap spread)
� Protects buyer from losses due to default
� Swap seller is long the credit risk only
224
Portfolio ManagementStudy Session 18
Weighting 5 – 15%
225
PORTFOLIO MANAGEMENT
Portfolio Concepts
A Note on “Market
Efficiency”
Portfolio Management Process & the Investment
Policy Statement
The Theory of Active Management
International Asset Pricing
Overview of Portfolio Management
226Mean and standard deviation
2,12122
22
21
21 2
:assets2for e.g.
Covwwwwport � ��� Covi,j =
E[(Ri-E(Ri)) (Rj-E(Rj))]
Variance(for standard deviation take square root)
Expectedreturn
For a portfolioFor an individual investment
jifor
1 1 1
222
%
� � � �n
i
n
i
n
jijjiiiport Covwww ��
���
����
� ��
return potentialy probabilit
)(RE )()(1
i
n
iiport REwRE
�
�
��
�
�
��
�
����
����
����
22 )(RE
returnpotential
prob�
ji
ijCovr
���ij n,Correlatio
If estimating an investment’s E(R) & s from time series data
then use these formulae, but use
actual return for each period in place of
potential, and set all probs equal
Most important factor when adding an investment to a portfolio that
contains a number of other investments is average covariance
with all the other investments
227Mean Variance Analysis
..
.
A
B
C.
D
�
E(R)
..
.
A
B
C.
D
�
E(R)BCD is the
efficient frontier
opportunity set of available portfolios
ABCD is the minimum variance frontier
Assumptions:• Investors are risk-averse• Investors know expected returns,
variances, and covariances for all assets
• Investors use Markowitz framework
• Frictionless markets: no taxes or transactions costs
Minimum Variance Frontier--Smallest variance among all portfolios with the same expected returnConstruction:1. Estimation: Forecast expected return, E(R), and variance, 2, for each individual asset2. Optimization: Solve for weights that minimize the portfolio 2 given target return and portfolio
weights that sum to one3. Calculation: Calculate E(R) and 2 for all the minimum variance portfolios from Step 2
228Correlation and DiversificationLower correlation � higher bow �greater diversification
This is for a two-asset portfolio
E(r)
30%
20%
10%
0%0% 10% 20%
Total Risk
= –1= –0.3
= +0.3
= +1
Variance for an equal-weightedportfolio:
2 2P i
1 n 1� = � + Covn n
�
229Adding in a risk-free assetCombinations of a risk portfolio and a risk-free asset will lie on a
straight line:
Standard deviation
Expe
cted
Ret
urn
..P
RF
Lending at RF
Borrowingat RF .
.PRF
.MCM
LE(R)
�
Hence, given assumptions on next slide: CML (Capital Market Line)
M is the market portfolio (optimal risky portfolio)
All investors want to be on
CML
230CML vs. CAL
Security Market Line CMLRisk measure Systematic Total
Application Required return for securities
Asset allocation for Rf and M
Definition Graph of CAPM Graph of efficient frontier
Slope Market risk premium Sharpe ratio
• The Capital Market Line assumes homogeneous expectations
• CML Equation
• The Capital Allocation Line assumesheterogeneous expectations
• CAL Equation
C�� �
���� �
M
FMFC
R-)E(RR)E(R C�� �
���� �
T
FTFC
R-)E(RR)E(R
231
Total Risk
MarketRisk
Total Risk = Unsystematic Risk + Systematic Risk
Unsystematic Risk
Systematic Risk
Number of Stocks in the Portfolio
Systematic vs. Unsystematic Risk
232Using the SML
.RF
.MRM
�i
E(Ri)
�M=1
SML
.RF
.MRM
�i
E(Ri)
�M=1
SML
SML shows expected return
(per CAPM)
Compare this to anticipated
(forecast) return
• A stock that is overpriced will plot below the SML
• A stock that is underpriced will plot above the SML
• A stock that is correctly priced will plot on the SML
E(Ri) = RF + �i(E(RM)- RF)
= Expected Return – Required Return
233CAPM in The Real World
Two key assumptions…1. Investors can borrow/lend at risk-free rate2. Unlimited short-selling and access to short proceeds
…yields two implications…1. Market portfolio lies on the efficient frontier (market portfolio is efficient)2. Linear relationship between expected return and beta
If the 2 key assumptions are violated…1. Market portfolio might lie below the efficient frontier (might be inefficient)2. Relationship between expected return and its beta might not be linear
234The Market Model
LOS 71.a: discuss how the Index Model simplifies CAPM
• Regression of an asset’s returns against an observable index’s returns:
• Expected return:
• Variance:
• Covariance:
E(Ri) =�i +�iE(RM)
Ri = �i + � iRM +�i
�i2 � � i 2�M2 ��
2
Cov ij = � i� j� M2
Beta Instability Problem� Historical beta not necessarily a good predictor of future relationships….
Adjusted beta� Mean-reverting level of beta = 1� Adjust beta to reflect this mean-reverting level
i,t = 0 + 1 i,t–1, where 0 + 1 = 1Most popular values: 0 = 1/3 and 1 = 2/3
� Adjustment moves beta towards 1� Adjusted beta moves toward 1 more quickly for larger values of 0
235Active Risk and Return
• Active return is the difference between the portfolio return (P) and its benchmark (B): RP – RB
• Active risk (“tracking risk”) is the standard deviation of the active return
• Source of active risk can be active factor risk and active specific risk
• Factor portfolio vs. tracking portfolio
Information RatioActive return per unit of active risk
Measures manager’s consistency in generating active returns
P B
P B
(r r )IR=s(r r )
��
236Multifactor models/APT
& & & &
APT (Arbitrage Pricing Theory)
= sensitivity of the actual return from security i to changes in an index representing risk factor k
& = the difference between the expected return for a one- unit exposure to factor k and the risk-free return
APT assumptions:
• Security returns can be described by a factor model
• Sufficient securities to diversify away the unsystematic risk
• No arbitrage opportunity
CAPM assumptions:• Competitive capital market• Markowitz investors• Unlimited risk-free
lending/borrowing• Homogenous expectations• One-period investment
horizons• Frictionless markets
Multifactor models
• analyst chooses number and the identity of the factors -enough so model adequately predicts security returns (but not too many)
• Macroeconomic models use underlying economic influences (e.g. real GDP growth, unexpected inflation)
• Fundamental factor models use specific aspects of the securities (e.g. P/E ratio, firm size)
237International Asset Pricing
Real Exchange Rate RiskThe possibility of exchange rate changes that are not explained by inflation differentials
Real exchange rate = spot rate x foreign price leveldomestic price level(dc/fc)
%� real spot = %� nominal spot rate – (inflationQ – inflationB) (dc/fc)
238ICAPMForm of ICAPM:
E(R) = Rf + bGMRPG + '1FCRP1…… + 'kFCRPk
whereE( R) = expected return required on investment xRf = risk free rate in investor’s home country (domestic)bG = the world beta of stock x (sensitivity to changes in global portfolio value)MRPG = the world risk premium'k = sensitivity of stock* x to changes in real exchange levelsFCRPk = foreign currency risk premium
Foreign Currency Risk Premium
OR
Domestic Currency Sensitivity
Exporter 'LC < 0Importer 'LC > 0' = domestic currency sensitivity'LC = local currency sensitivity
' = 'LC + 1
*in domestic currency returns
� �basequoted r-rS
S-)E(S=FCRP0
01��
����
FCRP = E(S 1) - FS0
239Equity & Bond ExposuresCurrency Exposures of National Economies
Equity Markets Bond Markets
Increased long-runeconomic activity
Currencydepreciation
Higher equityprices
causes
causes Negativecurrencyexposure
Traditional Model
Increased long-runeconomic
activity
Currencyappreciation
Higher equityprices
causes
causes
Positivecurrencyexposure
Money Demand Model
Increase in realinterest rates
Currencyappreciation
Lower bondprices
causes
causes Negativecurrencyexposure
Free Markets Theory
Government to decrease real
rates
Currencyappreciation
Higher bondprices
causes
causes Positivecurrencyexposure
Government Intervention Theory
240Active Management
Treynor-Black Model:• Only a limited number of securities are analyzed. The rest are assumed to be fairly priced.• The market index portfolio (M) is the baseline portfolio. The expected return and the
variance of M are known.• To create the active portfolio:
• Estimate the beta of each security to find mispricings. Those with non-zero alphas will be put into the active portfolio with the following weights: (+ alpha � + weight, - alpha � -weight)
• The cost of less-than-full diversification comes from the non-systematic risks of the mispriced stocks, 2(e), which offsets the benefit of the alphas.
• Estimates of , and 2(e) are used to determine security’s weights (+ or -) in the active portfolio n
A i ii=1
� = w�n
2 2 2A i i
i=1� (� )= w� (�)
Active management and market equilibrium:• empirical evidence:
• abnormal returns produced by some managers• some anomalies in realized returns have persisted over prolonged periods
• if no one can beat the passive strategy, money will flow away from active managers and their expensive analysis - prices will no longer reflect sophisticated forecasts - subsequent profit opportunity lures back active managers who once again become successful
n jii 2 2
j=1i j
��w =� (�) � (� )
n
A i ii=1
� = w�
241Active ManagementTreynor-Black Model (cont’d):• The expected return and the standard deviation of the Active portfolio (A):
E(RA) = A + A{E(RM) – RF}
• Combine the active portfolio and M to create the optimal portfolio which will maximize the Sharpe’s ratio
• When short positions are prohibited, simply discard stocks with negative alphas.• We should adjust the alpha estimated by an analyst by his past accuracy. Therefore if a
manager has consistently overestimated alpha on a stock in the past, we have to “discount” his analysis . That will give a smaller weight to the stock
2 2 2A A M A� = � � +� (� )
242The portfolio management processSteps:1. Planning
• Specify investor’s objectives and constraints• Create the investment policy statement (IPS) –
formal document governing all investment decision making, with a central role in the whole portfolio management process
• Formalize capital market expectations• Create the strategic asset allocation
2. Execution step• Construct a portfolio with the appropriate asset
allocation3. The feedback step
• Monitor objectives and constraints and capital market conditions, rebalance portfolio as needed
Objectives:• Return• Risk tolerance
(ability & willingness)
Constraints:• Time horizon(s)• Liquidity needs• Taxes• Legal & Regulatory needs• Unique circumstances
Typical IPS elements:• Client description• Purpose of the IPS• Identification of duties and
responsibilities• Formal statement of objectives
and constraints• Calendar schedule for portfolio
performance and IPS review• Performance measures and
benchmarks• Considerations for developing
the strategic asset allocation• Investment strategies and
investment styles• Guidelines for portfolio
adjustments and rebalancing
Time horizon directly affects ability to take risk
Importance of ethicalconduct (managers are in
a position of trust)
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